Money, Credit and Price Stability (Routledge International Studies in Money and Banking)

Money, Credit and Price Stability

How can monetary policy raise economic growth without sacrificing price stability? The experience of relatively high inflation after the oil shocks of the 1970s led many countries to give their central banks renewed mandates to focus their monetary policies on maintaining price stability. This has successfully controlled inflation but raises other questions about unemployment and economic growth. Earlier models of money and credit treated money as the medium of exchange. However, new technologies in finance and banking mean that people are becoming more reliant on cheques and EFTPOS accounts to pay for purchases and settle debts, implying a critical role for bank credit. Beginning with the development of credit-money theory in the twentieth century, Paul Dalziel derives a model that explains how interest rates are used by authorities to maintain price stability, and suggests how the current policy framework can be improved to promote gowth. This model is able to analyse the optimal debt decisions of firms, the liquidity preference of households and the equilibrium interest rate and growth of an economy. It shows that, when optimal funding decisions by firms lead to more deposits being created through bank loans than households are willing to hold, this creates inflationary pressure. The central bank can respond by raising interest rates, which reduces the demand for bank loans and so reduces the quantity of deposits. This analysis suggests a number of ways in which policymakers can promote the economy’s highest possible sustainable growth rate without sacrificing price stability. Money, Credit and Price Stability is an innovative new work that will prove to be essential reading not only for advanced students and academics with an interest in Keynesian economics, but also for professionals concerned with monetary theory and policy. Paul Dalziel is Senior Lecturer in Economics at the University of Canterbury, New Zealand.

Routledge International Studies in Money and Banking

1 Private Banking in Europe Lynn Bicker 2 Bank Deregulation and Monetary Order George Selgin 3 Money in Islam A study in Islamic political economy Masudul Alam Choudhury 4 The Future of European Financial Centres Kirsten Bindemann 5 Payment Systems in Global Perspective Maxwell J Fry, Isaak Kilato, Sandra Roger, Krzysztof Senderowicz, David Sheppart, Francisco Solis and John Trundle 6 What is Money? John Smithin 7 Finance A characteristics approach Edited by David Blake 8 Organisational Change and Retail Finance An ethnographic perspective Richard Harper, Dave Randall and Mark Rouncefield 9 The History of the Bundesbank Lessons for the European Central Bank Jakob de Haan 10 The Euro A challenge and opportunity for financial markets Published on behalf of Société Universitaire Europé enne de Recherches Financières (SUERF) Edited by Michael Artis, Axel Weber and Elizabeth Hennessy 11 Central Banking in Eastern Europe Nigel Healey 12 Money, Credit and Price Stability Paul Dalziel

Money, Credit and Price Stability

Paul Dalziel

London and New York

First published 2001 by Routledge 11 New Fetter Lane, London EC4P 4EE Simultaneously published in the USA and Canada by Routledge 29 West 35th Street, New York, NY 10001 Routledge is an imprint of the Taylor & Francis Group This edition published in the Taylor & Francis e-Library, 2005. “To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.” © 2001 Paul Dalziel All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data Dalziel, Paul. Money, credit and price stability/Paul Dalziel. p. cm. (Routledge international studies in money and banking) ISBN 0-203-18785-7 Master e-book ISBN

ISBN 0-203-18908-6 (Adobe eReader Format) ISBN 0-415-24056-5 (Print Edition) 1. Monetary policy. 2. Money. 3. Credit. 4. Economic stabilization. 5. Price regulation. I. Title. II. Series. HG230.3 .D35 2000 332.4–dc 00-036894 CIP

Contents

List of figures List of tables Foreword Preface 1 The quest for price stability

vi vii viii x 1

2 What is money?

16

3 Credit-money and inflation

28

4 Critical realism and process analysis

43

5 Keynes’s revolving fund of investment finance

53

6 Davidson’s analysis of the revolving fund

65

7 A theory of credit-money inflation

75

8 Inflation and growth

87

9 Fiscal deficits and inflation

98

10 Monetary policy and price stability

108

11 Conclusion

124

Appendix: Notation Notes References Index

136 139 148 170

Tables

3.1 Bank of England Issue Department balance sheet as at 28 February 1999 3.2 Barclays PLC consolidated balance sheet as at 31 December 1998 3.3 United Kingdom banks aggregated balance sheet as at February 1999 3.4 Non-bank economic agent balance sheet 4.1 Process analysis of Mr Meade’s Relation 5.1 Kaldor’s revolving fund with a non-instantaneous multiplier 6.1 Balance sheet for firms 6.2 Balance sheet for firms after retained profits 7.1 Aggregate balance sheets for firms and households 7.2 Expanded aggregate balance sheets for firms and households 7.3 Changes in the aggregate balance sheet for firms 8.1 Aggregate balance sheets for firms 9.1 Conceptual public sector balance sheet 11.1 Credit-money as ‘intermediated capital’

29 30 30 34 50 62 71 71 77 77 79 89 103 125

Figures

1.1 Consumer price inflation of English-language OECD countries, 1960–98 1.2 The Kydland–Prescott model 3.1 The monetary circuit for the production of consumption goods 5.1 A generalised demonstration of Mr Meade’s Relation 5.2 The classical theory of saving and investment 5.3 The monetary circuit for the production of investment goods 5.4 Process analysis of Keynes’s revolving fund of investment finance 5.5 Keynes’s revolving fund with an instantaneous multiplier 6.1 Keynes’s revolving fund with liquidity preference 6.2 A two-period model of the revolving fund with credit-money 7.1 The classical theory of saving and investment with forced saving 8.1 The optimal marginal debt–capital ratio locus 8.2 The optimal marginal debt–capital ratio and equilibrium growth rate 8.3 Exogenous shocks to the marginal efficiency of capital 9.1 Process analysis of a budget deficit 10.1 Broad money supply nominal growth, New Zealand, 1959/60 to 1998/9 10.2 The IS–LM AS–AD theoretical framework for monetary policy 10.3 Price stability through monetary restraint 10.4 Price stability with interest rate responsiveness effects 10.5 The optimal policy mix 11.1 The foreign exchange market 11.2 The foreign exchange market with a higher domestic interest rate 11.3 New Zealand exchange and interest rates, January 1990 to December 1999

2 7 38 54 57 59 60 63 68 74 84 94 95 97 100 109 114 117 119 121 132 133 135

Foreword

I am delighted to write a foreword to Paul Dalziel’s splendid book. We first met in 1994, when he spent six months’ leave in Cambridge. We had many discussions on economics and other matters and exchanged the usual daily insults required between Australians and New Zealanders. I had already read some of his papers and had admired them for their clarity and insight. Meeting Paul and his partner, Jane Higgins, was a joy and an inspiration in equal measure. Here were two socially committed, passionate and caring scholars courageously bucking the current trends in theory and policy in their disciplines and in their country. Such integrity has always been rare, and no more so than in recent times. Paul brings to his writings a powerful command of modern techniques allied with a deep feeling for actual economic and social processes at work in small open economies such as New Zealand and Australia. He has a fine understanding of the interactions between the real and the monetary sectors of the economy, and of the relationships between the flows and stocks of both sectors, within and between them. In a very real sense he is pushing forward in the contemporary world the rich analysis that was originally to be found in Keynes’s two major works, A Treatise on Money, Volume 1: The Pure Theory of Money (1930) and The General Theory of Employment Interest and Money (1936). By tracing out relationships between the flows of expenditure, income and credit, and their impact on stocks of real and financial assets, and by cleverly using process analysis, he is able to tell a convincing story concerning the inflationary processes at work in New Zealand and similar economies. Moreover, he gives as much weight to asset inflation as to commodity inflation. By identifying their causes, he opens the way to sensible policy suggestions that remove inflationary pressures without having the needless suffering of heavy unemployment in order to create a cowed labour force, that is to say, endorsing the orthodox approach to the control of inflation. In making his analysis and diagnosis, Paul restores the primacy of investment and demand-side factors generally in determining activity in the shorter and longer term. Supply-side factors are not ignored but are given their proper place. Money is credit-money, endogenously determined by requests from spenders to banks for credit, taking into account interest rates and other means of allocating credit. Not for him the modern practice of using a representative agent – a Ramsey maximiser

Foreword

ix

allied with a production function and commodity money – to analyse macroeconomic processes. All told, he has provided a blueprint for further advances in realistic useful theory and its application in effective policies – exactly the contribution that economists who belong to the tradition that Paul graces should make. It is a privilege to be associated with the volume and its author. G. C. Harcourt Jesus College, Cambridge February 2000

Preface

The research project reported in this book started at the beginning of my sabbatical leave in August 1993 as a six-page working paper containing a simple idea: an increase in investment expenditure financed by endogenous credit-money creation triggers two different processes: the multiplier process, by which the income– expenditure circular flow increases real income, and the portfolio-adjustment process, by which the extra money thus created comes to be willingly held. In that paper, it was assumed that all of the credit-money created to finance the investment would remain in circulation at the end of the two processes. During my four-month period as Visiting Scholar in the Centre for Rural Social Research at Charles Sturt University, Australia, I discovered Keynes’s (1937c, d) theory of investment, which made exactly the opposite assumption – that the same credit-money can be used over and over again in a revolving fund of self-replenishing finance – and Davidson’s (1972) book, which analysed the case in which Keynes’s assumption was not guaranteed. Reflection on these sources led me to introduce a new behavioural parameter into my model, the marginal debt–capital ratio, defined in Chapter 7, which would equal one under my initial assumption and would equal zero under that of Keynes, but which might typically be expected to lie between zero and one, as suggested by Davidson. This allowed a mathematical formula to be derived, linking inflation to the value of this debt–capital ratio and to the rate of economic growth. A paper based on this result was presented to seminars to the Departments of Economics at Macquarie University (21 October 1993) and the University of Sydney (4 November 1993), providing the basis (considerably modified by subsequent research) for the relationships derived here in Chapters 7 and 8. Although my research in Australia produced an interesting mathematical relationship, I did not at that time understand the mechanism that linked the endogenous credit-money and inflation, nor could I see how the mechanism could be discovered. While in the United States on the way to Cambridge University, England, for the second half of my sabbatical, I began tracing out the Keynesian multiplier process with the associated monetary flows in a rudimentary diagram that eventually became Figure 5.4 in Chapter 5. Once in Cambridge, Geoffrey Harcourt pointed out to me the similar diagram presented by James Meade (1993). It was then a short step to draw Figure 6.1, and to begin exploring in the mathematics the impact of a credit-induced inflation on the real value of saving relative to the

Preface xi

real value of equity not acting as bank collateral. To complete the mechanism, all that was required was an explanation of how an increase in the nominal price of capital translates into the nominal price of production; a question that was answered once I assumed that firms are obliged to earn a given rate of return on the value of their capital stock (discussed here at the end of Chapter 10 and in Chapter 11). These ideas were written up as a research paper that was subsequently presented to seminars to the Economics Departments of the University of Modena, Italy (12 April 1994), Cambridge University, England (29 April 1994), Stirling University, Scotland (7 May 1994) and the University of East London, England (2 June 1994). The ideas in that paper have been subsequently rewritten as Chapters 6 and 7 of this book. The discovery of James Meade’s (1993) note also introduced me to a methodology in economics known as ‘process analysis’ that has largely disappeared from the mainstream of current economic research. Meade’s account describes the role played by this methodology in the development of Keynes’s General Theory, which gives it considerable interest in its own right, but process analysis also fits in well with the critical realist philosophy of social science that is being explored in a weekly series of workshops on Realism and Economics at Kings College, Cambridge. As a result, I presented a seminar on ‘Process Analysis, Realism and Macroeconomics’ at the workshop of 2 May, 1994, and a revised version of that paper has become Chapter 4 in this study. On my return to Lincoln University, New Zealand, in September 1994, I began the task of exploring the implications of this study’s theory of inflation with endogenous money for monetary policy. This proceeded in two steps. First, optimality conditions had to be derived for the marginal debt–capital ratio that drives inflation in the model, which also required a theory of the supply-side capacity growth rate in equilibrium. The result of this research is reported in Chapter 8. Second, the analysis had to explain how changes in the central bank’s base interest rate could affect those optimality conditions. This is presented in Chapter 10. An early version of the material in these two chapters was presented at a seminar in the Economics Department of the Reserve Bank of New Zealand on 13 February, 1995. By the end of 1995, the model had reached a point where a paper entitled ‘A Keynesian Theory of Monetary Inflation Without Government’ was accepted for presentation at the Royal Economic Society’s annual conference at Swansea in April 1996, and a paper entitled ‘Central Banks and Monetary Control When Credit-Money Finances Investment’ was invited for presentation at a monetary circuit conference at the University of South Paris a few days later. Participation in the second of those conferences has led to the inclusion of some aspects of the monetary circuitist approach in this study (see especially Figures 3.1 and 5.3), whereas participation in the Swansea conference pointed me in a completely different direction. In particular, anonymous referee comments after the Swansea conference suggested that my research would benefit from studying the American economics literature on finance and money beginning with Gurley and Shaw’s (1960) famous book.

xii

Preface

Following that advice, I applied in 1997 to the New Zealand government’s Marsden Fund for a research grant to undertake a literature review and further theoretical research based on credit-money models of inflation. This application was successful and led directly to the survey in Chapter 2 (which first appeared in the Journal of Economic Surveys) and to the preparation of two theoretical conference papers: ‘Towards a Post-Keynesian Theory of Credit-Money Inflation’ presented at the Journal of Post Keynesian Economics 20th Anniversary Conference in Knoxville in June 1998, and ‘A Finance Theory of Credit-Money and Inflation’ presented to the Econometrics Society Australasian Meetings in Sydney in July 1999. The work preparing those papers, and the comments received from conference participants, have greatly improved the presentation of many aspects of this book. It should be clear from the above account that writing this book has been for the author something in the nature of Joan Robinson’s collection of ‘pieces of the jigsaw puzzle’ (1937, p. 6). In the course of turning up the various pieces of this jigsaw, I have incurred many debts. On a personal level, Hugh Campbell and Marion Familton in Wagga Wagga, Jimmye and Helen Hillman in Tucson, and Joan and Dan Pauly-Schneider in Minnesota made Jane Higgins and myself welcome in their homes for extended times during our sabbatical leave. Colleagues and support staff in the Faculty of Social Sciences and the Centre for Rural Social Research at Charles Sturt University, in the Faculty of Economics and Politics at Cambridge University, and at Wolfson College, Cambridge, gave generously of their time and expertise to ensure that I had access to all the academic resources I needed for my research. Participants in the various seminars at which I have presented parts of this book, and email correspondents around the world, have been unfailingly courteous, and provided many important suggestions and questions that have become part of the final product. In this context, I would like to thank Trond Andresen, David Archer, Sonmez Atesoglu, Harry Ayre, Michelle Baddeley, Keith Bain, Diana Barrowclough, Santonu Basu, Bruce Beattie, Jorg Biböw, Harry Block, Leo Bonato, Lois Bryson, Bruce Caldwell, Bryan Chappell, Bob Clower, Flavio Comim, Trevor Coombes, John Cornwall, Ken Coutts, Ross Cullen, Peter Docherty, Kevin Dowd, Gary Dymski, Brian Easton, Giuseppe Fontana, Craig Freedman, Rodriguez Fuentes, Andrea Ginzburg, Murray Glickman, Augusto Graziani, Bob Gregory, Alfred Guender, Louis Haddard, Joseph Halevy, Nick Hanley, Eric Hansen, Alfred Haug, Kim Hawtrey, Gunnar Heinsohn, Jimmye Hillman, Bernard Hodgson, Brian Holley, Christos Ioannidis, Roselyne Joyeux, Bill Junior, James Juniper, Steve Keen, David King, Lila Kirilik, Peter Kreisler, Marc Lavoie, Fred Lee, Brian Loasby, Mike Marshall, David Mayes, Marco Mazzali, Philip Meguire, Alex Milmow, Basil Moore, Tracey Mott, Peter Mottershead, Penny Neal, Chris Niggle, Adrian Orr, Les Oxley, Alain Parquez, Gabriele Pastrello, Jonathan Perraton, Tony Phipps, Robert Pollin, Stephen Pratten, Bill Rao, Weshah Razzak, Colin Rogers, Jochen Runde, Amal Sanyal, Caroline Saunders, Malcolm Sawyer, Ulrich Schwalbe, Mario Seccareccia, Robert Skidelsky, Frank Skuse, Jeff Sheen, Pierre Siklos, Matthew Smith, Clive Spash, Lester Taylor, Andrea Terzi, Jan Toporowski, Scan Turnell,

Preface

xiii

Bernard Vallageas, Paul Walker, Beth Webster, Graeme Wells, Graham White, Adrian Winnett, Alan Woodfield, Michael Woodford, Randall Wray, Julian Wright and Stephen Wright. Some colleagues deserve special mention. Peter Earl was appointed Professor of Economics at Lincoln University in June 1991, and ever since I have enjoyed many stimulating conversations with him about Keynes’s economics and postKeynesian monetary theory. Peter never failed to provide important comments on every piece of work I showed to him, including the original working paper that launched the research presented in this book. It was also Peter who suggested I should write to Geoffrey Harcourt to ask if I might spend a portion of my sabbatical leave in Cambridge. Apart from the warm and generous hospitality that Geoffrey gave me during my seven months as his guest, he was also a rich source of information concerning anything I wanted to know about the last six decades of the post-Keynesian literature, and many of the jig-saw pieces included in this study came from following up his suggestions. Geoffrey read everything I gave to him, always returned with extensive and fruitful suggestions scribbled in the margin, and then kindly offered to write the foreword to this book. While I was in the United Kingdom in 1994, and through correspondence since, my work benefited particularly from the insights of Philip Arestis, Victoria Chick, Sheila Dow, Steve Fleetwood, Peter Howells and Tony Lawson, and their influence will be discernible in the pages that follow. In the United States, Paul Davidson has been similarly inspiring, not only through his seminal writings on the topic of this book but also in his continuous provision of encouragement and helpful comments as the editor of the Journal of Post Keynesian Economics. I am grateful to Lincoln University for granting me twelve months’ sabbatical leave in 1993–4 to begin this research project and for financial assistance to consult with colleagues in New Zealand and overseas during the following three years. I am also pleased to acknowledge financial assistance from the Reserve Bank of New Zealand (to attend the Royal Economic Society Conference in 1996) and the Economics Department of the University of Canterbury (which I joined in June 1999). In 1998 and 1999, my research was supported by the Marsden Fund administered by the Royal Society of New Zealand (research grant LIU701), which made the writing of this book possible. I am very grateful to the Marsden Fund Committee and staff for their support. Finally, I am happy to record what a delight it has been carrying out this research in the company of Jane Higgins, whose own research on youth unemployment and social policy in New Zealand has been a perpetual reminder of the need to better understand the mechanisms and processes by which economic policies affect so many lives, for better or for worse. Paul Dalziel September 2000

1 The quest for price stability

One of the oldest ideas in economics is the quantity theory of money; indeed, The New Palgrave describes the proposition that increases in the stock of money eventually cause prices to rise in the same proportion as being ‘older than economic theory itself (Bridel, 1989, p. 298). With suitable extensions to recognise the impact of changes in the volume of economic transactions or the velocity of circulation (Fisher, 1911), and more generally the impact of changes in real money demand (Friedman, 1956), this long-standing theory remains the starting point for much modern analysis in monetary economics. In particular, its strong causal link between changes in the money supply and changes in the price level offers a clear strategy for achieving price stability: those responsible for controlling the money supply should be given a statutory duty to implement policy that is consistent with a pre-announced low inflation target. New Zealand was the first country to reform its central bank legislation along these lines (in 1989), and its example has been followed by others since (including Canada in 1991, the United Kingdom in 1997 and the European Central Bank in 1998). The result has been a clear improvement in inflation performance by the end of the twentieth century compared with the previous three decades (see Figure 1.1). Despite the success of the new monetary framework in controlling inflation, there remains a puzzle that this book seeks to address. To be effective for policy purposes, the quantity theory of money requires that the central bank has the ability to determine the nominal money supply exogenously (that is independently of other economic influences) so that its growth can be set to be consistent with the bank’s inflation target. In practice, however, monetary authorities do not have direct control over the monetary aggregates, and indeed the English-language central banks that attempted to target money supply growth rates in the 1970s abandoned that practice in the 1980s. The difficulty is that virtually all money in modern economies takes the form of bank deposits that are created, not by the monetary authorities, but by the credit extension activities of private sector banks. Consequently central banks are able to influence the volume of this credit-money only indirectly, particularly through policy-induced changes in the banking system’s base interest rate. Analysing the critical roles of credit in determining money supply growth and as a key component of the transmission mechanism from monetary policy to price stability is the primary subject of this book and provides its title, Money, Credit and Price Stability.

Figure 1.1

Consumer price inflation of English-language OECD countries, 1960–98 Source: International Monetary Fund International Financial Statistics, October 1999

The quest for price stability

3

In contrast to the exogenous money model underlying the quantity theory of money, the framework adopted in this study is termed the ‘endogenous money’ model. Since the creation of credit-money by the financial system is governed by economic incentives, rather than any mechanical relationship to the monetary base, previous studies using the endogenous money framework have typically denied any policy role for the quantity theory, arguing instead that inflation is the result of other considerations such as excessive growth of aggregate demand (Kaldor, 1970: p. 1), income distribution conflict (Weintraub and Davidson, 1973: p. 1125) or self-fulfilling expectations (Black, 1986: pp. 539–10). This book argues that this rejection is too strong, and demonstrates that once the central bank’s base interest rate determines the aggregate money stock indirectly – by affecting the lending activities of banks – the quantity theory of money can then be used to show how the price level is determined through the portfolio decisions of wealth holders. Although this study may therefore be considered as a reconciliation of the exogenous and endogenous approaches, it also draws conclusions that are likely to be anathema to both sides of this sometimes bitter debate. In particular, exogenous theorists are likely to object to the result that monetary policy may not be neutral with respect to real economic growth, even in the long run, whereas endogenous theorists may object to the implication that inflation can be a genuine monetary phenomenon that can be controlled by the central bank. With this in mind, the chapters that follow seek to explain at each step of the argument how the model is derived from the previous work of important monetary theorists, and how it is consistent with actual macroeconomic experience. In particular, the analysis in this book integrates the money and real sectors of the economy into a Keynesian model of finance, growth, inflation and monetary policy that is a considerable development on its predecessors. The remainder of this chapter elaborates on these major themes of the book. The first section describes the inflationary experiences of the six English-language OECD (Organization for Economic Cooperation and Development) countries (Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States) after 1960, and it relates how initial efforts to control inflation through incomes policies, price controls and monetary targeting gave way to the current policy framework based on base interest rate adjustments and inflation targeting. The next section then briefly summarises the exogenous and endogenous money models, providing representative quotations in each case to illustrate the corresponding fundamental assumptions being challenged in this study. The final section provides a précis of the chapters that follow, in order to present an overview of how the book will present its model and conclusions. The rise and fall of inflation in the late twentieth century Figure 1.1 presents time series data for the annual consumer price inflation rates of Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States between 1960 and 1998. These data reveal low inflation rates for most of

4

The quest for price stability

the 1960s, generally below 5 per cent. In the first half of the 1970s, however, inflation rates rose in all six countries, peaking at approximately 11 per cent in Canada and the United States and between 15 and 25 per cent in the other four countries. The first reaction of policymakers was a two-pronged approach based on incomes policies to slow wage or price increases and money supply growth targets to guide monetary policy. 1 In the United Kingdom, wages and prices were subject to statutory controls from November 1972 to July 1974, and the Labour government announced annual wage increase guidelines in each of its Budgets from 1975 to 1977. In mid-1976, the government also announced a growth target for the broad money supply (M3), a practice that continued with some refinements in subsequent years. In the United States, there was a sixty-day price freeze in June 1973, followed by informal incomes policies until President Carter, in October 1978, announced formal standards for wage and price increases to be administered by a Council on Wage and Price Stability. In 1975, Congress passed a resolution requiring the Federal Reserve to begin publishing and reporting on its success in achieving targets for growth in the money supply aggregates. In Canada, the government announced a three-year anti-inflation programme in October 1975, which included mandatory wage and price controls monitored and administered by the Anti-Inflation Board. In the same year, the Bank of Canada began announcing growth targets for the narrow money supply (M1). In Australia, a three-month price and wage freeze was imposed in April 1977, followed by partial indexation of wages set by the Commonwealth Conciliation and Arbitration Commission, while in August 1976 the Treasurer began the practice of announced projected growth in M3 over the twelve months to the following June. In New Zealand, a series of wage controls were imposed and small General Wage Orders were awarded throughout the second half of the 1970s, and the government continued to rely on regulated wage and price control measures right up until the early 1980s. 2 The incomes policies in the United Kingdom and the United States ended with changes of government in 1979 and 1980, leading to a much greater emphasis on setting and achieving money supply growth targets. In the former country, this was based on the government’s Medium Term Financial Strategy, which included targets for growth in the broad money supply, M3. In the United States, the Federal Reserve announced in October 1979 a greater dedication to achieving its money growth targets, and changed its major policy instrument to controlling nonborrowed bank reserves in line with the new focus. Ireland, Australia and Canada also turned towards a greater reliance on monetary restraint in the early 1980s to achieve disinflation. Ireland joined the European Monetary System at its inception in 1979 to boost the credibility of its commitment to monetary discipline. Canada successfully achieved pre-announced reductions in its monetary growth target between 1978 and 1981, and maintained tight monetary policy (despite monetary growth being below target) to offset inflationary pressures in 1982. Australia was not so successful in meeting monetary growth targets in the late 1970s, but in 1982 accepted real interest rates that were higher than had been seen before in that country in order to reduce inflation. New Zealand was alone among the six countries in not introducing policies of monetary disinflation; instead the Minister of Finance

The quest for price stability

5

announced a universal incomes and price freeze in June 1982, which remained in place until February 1984. Figure 1.1 records that inflation in these six countries was reduced from 10–20 per cent in 1980 to 4–9 per cent in 1984. Inflation rebounded in New Zealand after the end of its price freeze until monetary disinflation was implemented in earnest after April 1988 (Sherwin, 1999: p. 73). Australia also returned to a greater emphasis on an incomes policy following a change of government in 1983, accepting a somewhat higher inflation rate in the process. The other four countries continued to use monetary restraint over the next three years so that by 1987 inflation was down to 4.4 per cent in Canada, 3.1 per cent in Ireland, 4.2 per cent in the United Kingdom and 3.7 per cent in the United States. This second wave of monetary disinflation, however, was accompanied by a growing disenchantment with the practice of monetary targeting. Canada in 1982 found that the narrow money supply was well below its target growth rate at a time when inflationary pressures were high, and so monetary targeting was abandoned. In Australia, the opposite occurred – growth in the broad money supply for 1984/5 was 17.5 per cent compared with a target range of 8–10 per cent at a time when inflation was judged to be acceptable, and so monetary targeting was abandoned in early 1985. In October 1985, the Chancellor of the Exchequer in the United Kingdom delivered his ‘Mansion House Speech’, in which he declared that the sterling M3 target had been effectively suspended (although projected ranges continued to be published) after several quarters of high growth that had not been reflected in rising inflation. In 1987, the United States abandoned setting target growth rates for its M1, although it continued to publish broad money supply growth targets, following the collapse of prior empirical relationships between money and prices (Friedman and Kuttner, 1996). There are two broad explanations for the ending of monetary targeting during the 1980s. The first emphasises the possible loss of political will for achieving genuine price stability as the employment costs of monetary disinflation became apparent. 3 Rates of unemployment for five of the above countries peaked at around 10–12 per cent during their disinflations, and rose above 18 per cent in Ireland. Such high levels of unemployment created political pressures in favour of relaxing monetary policy once inflation had been reduced to moderate levels. The second explanation emphasises the way in which financial deregulation made previous relationships between the monetary aggregates and nominal gross domestic product growth totally unreliable. Thus when there was a conflict between a pre-announced money supply growth target and the monetary authorities’ projected inflation rate, the authorities began to place more and more weight on achieving their desired rate of inflation. In short, central banks began to move towards direct inflation targeting, rather than relying on any intermediate targets for money supply growth. 4 Consistent with the first explanation, inflation rates in some countries began to rise again towards the end of the 1980s, most notably in Britain, which experienced inflation of 9.5 per cent in 1990. This led to a period of renewed monetary restraint, accompanied by reforms that formalised the emerging practice of targeting inflation directly. In Canada, New Zealand and the United Kingdom, price stability is now

6

The quest for price stability

explicitly described as the sole objective of monetary policy (see, for example, Poloz, 1994: pp. 21–22; Dawe, 1990; Bank of England, 1993), and this commitment is accompanied by underlying inflation targets of 1–3 per cent, 0–3 per cent and 2.5 per cent respectively. Ireland enshrined price stability as the primary objective of its central bank in 1998 as part of the necessary steps to be a founding member of the European System of Central Banks in January 1999 (Bank of Ireland Annual Report, 1999: p. 24). In Australia and the United States, the governing legislation continues to mention employment or output goals, but statements by senior office holders have for several years made it clear that these will not be pursued at the expense of inflation (see, for example, Fraser, 1994; Greenspan, 1994). The Reserve Bank of Australia has also set a pre-announced inflation target of 2–3 per cent on average over a normal business cycle. By the mid-1990s, this reformed framework was successfully keeping inflation at low levels in all the countries shown in Figure 1.1. Exogenous and endogenous money theories The monetary reforms of the 1990s were based on the widely accepted economic theory that inflation is always and everywhere a monetary phenomenon and monetary growth is always and everywhere a government phenomenon. This can be illustrated with a number of representative quotations from the relevant literature: Whatever was true for tobacco money or money linked to silver and gold, with today’s paper money, excessive monetary growth, and hence inflation, is produced by governments. In the United States the accelerated monetary growth during the last fifteen years or so has occurred for three related reasons: first, the rapid growth of government spending; second, the government’s full employment policy; third, a mistaken policy pursued by the Federal Reserve System. (Friedman and Friedman, 1980: p. 264) The government determines the nominal money stock at the start of period t to be the amount Mt. No private issues of money are considered. (Barro, 1983: p. 3) We assume that the policymaker controls an instrument – say, monetary growth, μt – which has a direct connection to inflation, πt, in each period.... In effect, we pretend that the policymaker chooses πt directly in each period. (Barro and Gordon, 1983: p. 594) Inflation and taxes are set respectively by the central bank (CB) and by the fiscal authority (FA). Within the framework of this model, the hypothesis that the CB directly controls inflation amounts to assuming that money demand is not affected by fiscal policy. (Alesina and Tabellini, 1987: p. 622)

The quest for price stability

7

[There are] two political parties in this economy.... It is assumed that the party in power is able to directly control the inflation rate. (Waller, 1989: p. 424) For simplicity, [assume] that the policymaker controls the actual inflation rate exactly and can predict future expected inflation rates exactly. (Grossman, 1990: p. 167) Given that nobody is in favour of high inflation for its own sake, the assumption that governments control the rate of money growth – and hence inflation – raises an obvious question: why would a government choose a policy that produces high inflation? 5 The general answer given in the literature is that at any particular moment monetary restraint or expansion can have a short-term impact on unemployment that has political consequences for the government of the day. Following a suggestion first made by Kydland and Prescott (1977), this observation can be expressed in two stylised hypotheses: first, assume that the government’s objective inflation depends negatively on the inflation rate and negatively on the unemployment rate at any moment in time; and, second, assume that there is a negative Phillips curve trade-off between inflation and unemployment, given the currently expected rate of inflation. Let ut be the unemployment rate at time t, let pt be the inflation rate and let pet be the expected inflation rate, and suppose that un is the ‘natural’ rate of unemployment that prevails when pt = pet. Then the Kydland– Prescott model is presented in Figure 1.2.

Figure 1.2 The Kydland–Prescott model

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The quest for price stability

The social welfare function is represented by the three indifference curves labelled IC1, IC2 and IC3. The combinations of inflation and unemployment along each indifference curve are of equal value to the policymaker, but the points on IC1 are strictly preferred to those on IC2 which are in turn strictly preferred to those on IC3. The trade-offs available to the policymaker are represented by the three expectationsaugmented Phillips curves labelled PC. The level of expected inflation for PC1, PC2 and PC3 is, respectively, pe = 0, pe = the inflation rate at point B and pe = the inflation rate at point C. Within this framework, suppose that the government announces a commitment to price stability, and suppose that this is believed by the private sector. This implies pe = 0, and the Phillips curve passing through the origin is the relevant trade-off. Given this, it is clear that price stability is not the optimal choice for the government, since it can exploit the trade-off to move to point A (where the reduction in unemployment more than compensates for the rise in inflation, since point A is on a higher indifference curve than the origin). In the terminology of the literature, the announced commitment to price stability is not ‘time consistent’, since there is an obvious incentive for the government to renege on its commitment if the announcement is believed. Nor is this the end of the analysis. Since the inflation rate is positive, the private sector will adjust its expectations in line with its experience, so that the relevant Phillips curve becomes the one passing through point B. This process continues until the economy settles at a time-consistent equilibrium, point C, where an indifference curve is tangential to a Phillips curve at the vertical axis. At this point, the private sector expects the inflation rate to be that shown at C, and the government can do no better than deliver that inflation rate. Thus the analysis explains why a government that is concerned about the short-term impact of monetary policy on unemployment may end up trapped in a high inflation equilibrium. Further, if the government under these circumstances tried to deliver price stability – given that the private sector rationally expects it to choose the inflation rate at point C – the economy ends up at point D with a higher rate of unemployment than its natural rate. The tragedy of this outcome is that point C is clearly inferior to the original point 0. To offset the inflationary bias, therefore, the analysis suggests that policymakers should implement reforms that reduce the benefit to government from any policy-induced fall in unemployment. For example, it might grant policy independence to the central bank (so that the government gets neither reward nor blame if monetary policy is relaxed or tightened), and give the bank a single objective of maintaining some measure of price stability, as has happened in New Zealand, Canada and the United Kingdom. As another example, the government might attempt to tie its monetary policy hands by joining an external monetary system, as was the course of action taken by Ireland in 1979 and again in 1998. Alternatively, the central bank might undertake its own initiatives to establish a reputation for delivering low inflation independently of the political pressures felt by the government, as appears to be the case in Australia and the United States. All of these examples raise the credibility and time consistency of an announced commitment to low inflation and so makes the maintenance of price stability less costly.

The quest for price stability

9

The reforms just described have undoubtedly reduced the ability of governments to interfere with price stability compared with previous decades. The argument of this book, however, is that the monetary policy reforms of the 1990s are not sufficient for controlling inflation efficiently, for two important reasons. First, not all causes of inflation are monetary ones. In particular, it has long been recognised that a wage–price inflation spiral can be initiated in labour and product markets either because of price rigidities in those markets or because of a fundamental income distribution conflict among different sections of the population. 6 Such a spiral can always be dampened by restrictive monetary policy, but normally at the cost of high rates of business failure and unemployment in order to break down the market rigidities or market power fuelling the inflation. This can make monetary restraint terribly inefficient in controlling this type of inflation; in a memorable phrase Cornwall (1983: p. 283) describes it as ‘a clumsy instrument akin to blood-letting’. Consequently, a number of supplementary policies have been proposed that are more tightly focussed in their effects, based on the famous Calmfors–Driffill thesis that either a very decentralised or a very centralised labour market tends to perform better in terms of inflation and unemployment than a labour market that is neither one nor the other (Calmfors and Driffill, 1988; for a recent survey see Hargreaves-Heap, 1994: pp. 42–50). Thus, some advocate market reforms to improve the competitiveness of labour and product markets whereas others advocate some form of a coordinated incomes policy to resolve income distribution conflicts in a less costly fashion. 7 Second, and the primary focus of this present study, not all causes of monetary expansion come from the government. This may have been the case when all money was currency money under the control of sovereigns (but even then discoverers of new supplies of precious metals could affect the money supply and average price level), but it is not true in the present day where almost all money is credit-money, created through balance sheet transactions by private sector financial institutions. Thus, if central bankers are given sole responsibility for maintaining price stability, they must implement policies that restrict the ability of the private sector to create excess supplies of money. These policies are likely to involve a wide range of potential unintended consequences, but the monetary economics literature cited above provides no guidance on this problem precisely because it explicitly assumes all money is created by the government. This is an important gap in the research agenda of monetary economics. Just as previous research has helped us to understand better the causes of and cures for wage–price inflationary spirals, so also there needs to be research directed towards understanding better the causes of and cures for inflation due to excess expansion in the level of credit-money created by the private sector. This is necessary not only to analyse how current monetary policies influence this phenomenon, but also to design more focussed policies that can achieve price stability goals without imposing unnecessary restraints on other goals such as growth and full employment. The study reported in this book is directed towards these tasks. This study is by no means the first time that the question has been asked whether credit-money created by the private sector can contribute to inflationary

10

The quest for price stability

pressures. Instead, this question has been a significant field of research for over twenty-five years by a relatively small group of economists referred to as ‘endogenous money theorists’. The endogenous money literature will be surveyed in some detail in Chapter 3, but it should be noted here that the answer given by this group to the above question is a resounding no – inflation cannot be caused by excessive nominal money supply growth. Again this can be illustrated with a number of representative quotations. The main moral of the General Theory can be expressed by saying that the general price level in terms of money is not a monetary phenomenon; its movements depend mainly upon money-wage bargains; that is to say, it is very largely a political phenomenon. (Robinson, 1970: p. 512) If [employment] and [the mark-up of prices over unit labour costs] are given, then the (average) money wage emerges as the unique price level parameter without recourse to, or even mention of, money supplies. (Weintraub and Davidson, 1973: p. 1125) In technical parlance, the supply of credit-money is infinitely elastic at the given rate of interest and this alone rules out the possibility that an ‘excess’ supply of money relative to demand, or vice versa, should be the cause of a ‘pressure on prices’ upwards or downwards. (Kaldor, 1980: p. 294) Money is viewed as the outcome of credit creation; it is a residual and as such it cannot be the cause of any economic magnitudes. (Arestis, 1987–88: p. 265; see also 1992: p. 203) Inflation cannot be ‘caused’ by an excess supply of credit-money. An excess supply of credit-money, in the conventional sense of an unwillingness to demand additional quantities at the existing price, cannot exist so long as money retains its moneyness. (Moore, 1988c: p. 333) The level of money prices does not depend on the quantity of money. In fact, the quantity of money does not even appear in the equation for the price level. The money stock, being a totally endogenous variable, cannot enter into the determination of the price level. (Graziani, 1990: p. 23) The most obvious impact of an endogenous credit-money theory is on the theory of inflation. Since the supply of money is not an exogenous variable, it cannot be held responsible for the general increase in prices. Inflation cannot be caused by an excessive rate of growth of the supply of money due to

The quest for price stability

11

incompetent central bankers or to a favourable trade balance. Some other theory of inflation, different from the standard monetarist and now neoclassical view, must be provided. (Lavoie, 1992: p. 216) As has already been indicated, this study adopts the same endogenous money framework as these authors, but comes to a different conclusion. This is not because the research of the endogenous money school has been wrong in the past; indeed the analysis in Chapter 5 is able to explain the sense in which endogenous money should not lead to inflation using very similar arguments to those developed by the authors cited above. Nevertheless, the addition of a concept not previously considered in this context – the long-term funding by firms of their capital stock with bank loans and equity sales – is able to produce a monetary theory of inflation in which the monetary growth is generated entirely by the private sector. Within the framework produced by this theory, the search for more efficient mechanisms for controlling inflation therefore relies on finding more effective ways to ensure that this funding decision is compatible with monetary and price stability. Outline of the book The discussion so far will have made it clear that the study reported in this book is made up of elements that almost all monetary theorists will find novel in one aspect or another. On the one hand, the study does not accept that the money supply (and hence inflation) is under the exclusive control of policymakers, as monetarist and new classical economists have argued in the past, but it does make use of equilibrium analysis and the rational expectations hypothesis in the mathematical model of Chapters 7 and 8. On the other hand, the study does not accept that endogenously generated money can never cause inflation, as endogenous money theorists have argued in the past, but it does make use of process analysis and ‘Mr Meade’s Relation’ between investment and voluntary saving in Chapters 4, 5 and 6 to create the overall framework of enquiry. It may be useful, therefore, to conclude this introduction with an overview of the key elements of this study, so that readers can create for themselves a mental map of landmarks, some familiar and some unfamiliar, as they read the material that follows. The book begins in the following chapter with an essay on the way in which the social institution of money has evolved over the last century, posing new challenges for monetary theorists and policymakers in the process. The chapter focuses in particular in the transition from money as a unique commodity of exchange to money as a financial liability of the banking system. It draws attention to the way Maynard Keynes and Irving Fisher introduced bank deposits into their monetary analysis, to the debates this has generated about definitions of the money supply, to the arguments in favour of ‘free banking’ without central bank control, to Fischer Black’s finance theory of money and to the Wicksellian interest rate rule for monetary policy that is widely adopted by modern-day central banks.

12

The quest for price stability

Chapter 3 provides a summary of the theory of endogenous money creation. Its principal point of departure from orthodox theories of money creation is the attention it pays to the role of an economy’s banking system in creating creditmoney to finance the needs of production, particularly investment production. It is widely held that credit-money can never be in excess supply, and so the chapter presents a summary of ‘the law of reflux’, which is the foundation of this view. This highlights the critical assumption that the borrowers of bank loans are also the holders of bank deposits. If at least some bank depositors do not also have bank loans, this opens the door for credit to produce an excess supply of money. The standard solution to this disequilibrium situation is to assume that relative interest rates change to restore balance, which the chapter explains drawing heavily on recent work by Philip Arestis and Peter Howells at the University of East London. In this book’s framework, this mechanism is not available, and so the chapter concludes with a discussion of previous authors (notably Hyman Minsky and Victoria Chick) who have argued that an excess supply of endogenous money might be eliminated by price inflation (the theory of this book). The methodology adopted in this study is a combination of process analysis and equilibrium analysis. The latter approach will be familiar to all economists, but the former has tended to fall into disfavour outside the post-Keynesian school. Chapter 4 therefore provides an explanation and defence of process analysis, drawing on the philosophical perspective known as critical realism and on the role played by process analysis in the development of Maynard Keynes’s (1936) The General Theory of Employment Interest and Money. In particular, Table 4.1 presents a slightly adapted process analysis of James Meade’s (1993) account of how he came to prove in the early 1930s that a change in the level of investment necessarily leads to an equal change in the level of voluntary saving. This result, which Richard Kahn (1931: p. 188) termed ‘Mr Meade’s Relation’, provides the backbone to the mathematical modelling in later chapters. Chapter 5 continues to concentrate on process analysis, but begins the task of bringing together the analysis of real flows in Mr Meade’s Relation and the analysis of money flows in the endogenous money literature surveyed in Chapter 3. This has proved notoriously difficult in the past, 8 but it turns out to be a relatively simple matter to extend Meade’s diagram to incorporate Keynes’s theory of the revolving fund of investment finance presented in four important papers written after The General Theory. Chapter 5 contains a very general proof of one of the books foundational elements, called here the ‘conservation of saving’ principle. By assuming an instantaneous Keynesian multiplier process, this principle then allows the construction of a two-period model that tracks how money is endogenously created and destroyed in a monetary circuit of investment finance and equity sales. This result is in accord with the previous literature that has argued endogenous money is not inflationary. The framework introduced in Chapter 5 is extended in Chapter 6 to allow households to choose to hold some of their accumulated wealth in the form of money (that is bank deposits). Following Keynes’s terminology, this decision about the demand for money as a stock (rather than as a flow to finance immediate

The quest for price stability

13

expenditure) is analysed under the heading of ‘liquidity preference’. This chapter draws heavily on Paul Davison’s post-Keynesian writings to analyse the impact of household ‘hoarding’ on the revolving fund of investment finance. Allowance is made for the possibility that equity prices might depart from the price of capital goods (that is Tobin’s q-statistic might depart from its long-run equilibrium value of unity), but this is shown to have very little effect on the underlying process. The theory of the previous chapters creates a framework that can be summarised in two simple aggregate balance sheets, of firms and households, which are presented in Table 7.1. This exposes the critical roles played by the funding decision of firms each period and the liquidity preference decisions by households in determining changes in the supply and demand of credit-money respectively. In Chapter 7, the funding decision is represented by a parameter, d, termed here the ‘marginal debt–capital ratio’. This parameter measures the proportion of investment each period that at the end of the ensuing multiplier process remains funded by bank loans rather than through the sale of equities to household savers. The liquidity-preference decision, on the other hand, is modelled as the outcome of a simple constrained optimisation problem in which households maximise their utility subject to their overall wealth constraint. This gives rise to another important variable, h, termed here the ‘money–wealth ratio’, which is the portion of their wealth that households choose to hold in the form of money balances. In the model’s world of a single physical asset and no government, the economy’s wealth is just its stock of capital, and the loans borrowed by firms must by definition equal the value of deposits held as credit-money. In each period, therefore, investment expenditure creates new capital and new wealth that increases respectively the value of bank loans according to the marginal debt–capital ratio and the value of money demanded according to the money–wealth ratio. If the two parameters are not equal, Chapter 7 shows how inflation can reconcile the divergence, producing a simple relationship in Equation 7.13 between inflation and growth that depends only on the difference between the two parameters relative to the value of the money–wealth ratio. The chapter ends by showing how this private sector inflation produces a tax on start-of-period nominal money balances that is entirely analogous to the standard inflation tax analysed in the public finance literature. In this model, however, the tax is not received by the government but by the shareholders of the firms who see the real liability of their bank loans reduced by the inflation. The next question to ask is what influences firms in their choice of their marginal debt–capital ratio, d. Chapter 8 addresses this problem. It adopts a ‘representative firm’ model, which assumes that the firm chooses d to maximise the benefits to shareholders under the rational expectations hypothesis that it recognises the impact of its decision on the inflation rate. This analysis also introduces interest rates into the model, adopting Kalecki’s principle of increasing risk to suppose that the interest rate on bank loans rises as the marginal debt–capital ratio rises. The optimal value of the ratio is then obtained at the point where an increase in its value produces an equal marginal benefit (the resulting increase in inflation) and

14

The quest for price stability

marginal cost (the resulting increase in nominal interest rates), reproducing Irving Fisher’s famous relationship between the nominal and real rate of interest. The analysis of the optimal marginal debt–capital ratio produces an equation that depends on the economy’s supply-side capacity growth rate, g. Thus Chapter 8 also provides a model of the equilibrium growth rate, based on the Keynesian assumption that the level of investment each period is chosen to make the marginal efficiency of capital equal to the real rate of interest. This produces an equation that depends on the prevailing marginal debt–capital ratio, so that the economy’s optimal marginal debt–capital ratio and equilibrium growth rate are determined simultaneously. This is analysed using the diagram presented in Figure 8.2, which has the two relevant variables on its axes and contains a schedule for each of the optimising or equilibrium conditions. The point of intersection represents the economy’s optimal marginal debt–capital ratio and equilibrium growth rate, which together determine the economy’s inflation rate and real rate of interest. The chapter concludes by showing how the presence of random productivity shocks would generate data consistent with a negatively sloped Phillips curve. All of the analysis in Chapters 4–8 take place on the assumption that there is no government and hence no currency (base money). Chapter 9 relaxes this assumption, and it uses the same framework developed in the previous chapters to analyse the implications of a government choosing to finance an ongoing fiscal deficit by requiring the central bank to purchase public debt with base money. Although the framework is novel, the results are very familiar, producing the standard inflation tax discussed by, for example, Keynes (1923: pp. 37–53) and Friedman (1971). More interestingly, it is shown in Chapter 9 that the relationships thus produced can be interpreted as a special case of the relationship in Chapter 7. In both cases, the inflation arises out of deficit-financing that causes a gap between the change in the money supply and the change in money demand, which is then closed by an increase in the nominal value of wealth (the capital stock). The introduction of currency into the study paves the way for a discussion of modern monetary policy in Chapter 10. The first section describes New Zealand’s pioneering reform of its Reserve Bank in the late 1980s, with a brief outline of further monetary policy developments in the 1990s. This illustrates the way in which central banks have moved from quantity targets to base interest rate changes as the major instrument for maintaining price stability. The remainder of Chapter 10 then analyses how this instrument of monetary policy affects the incentives for private sector endogenous money creation. It turns out that there are two transmission mechanisms. On the one hand, an increase in the central bank’s base interest rate increases real interest rates. The model in Figure 10.3 shows that this is effective in controlling inflation but at the expense of lower investment and growth than might otherwise have been feasible. This is a standard result in the endogenous money literature of Chapter 3, and is a common critique of current monetary policy practice by post-Keynesian authors. On the other hand, the central bank’s interventions may also affect the marginal benefit and marginal cost of private sector money creation (particularly by raising the responsiveness of nominal interest rates to increases in the marginal debt–equity ratio). Figure 10.4

The quest for price stability

15

shows that this allows inflation to be controlled with less cost to growth, and it suggests that there may be other policies that would reinforce this effect without sacrificing the price stability goal. These policies include well-established considerations in the existing literature, such as building a reputation or institutional incentives for being ready to raise interest rates quickly in response to rising inflationary expectations. Alternatively, a second instrument targeted specifically at restraining the incentives for private sector credit-money creation (for example a capital gains tax) could allow an optimal policy mix to deliver both price stability and the maximum rate of economic growth consistent with supply-side constraints. The chapter concludes by showing how the price of equities (which is the subject of this book’s theoretical analysis) can be related to the price of consumption goods (which is the measure of price stability adopted by most central banks that publish inflation targets). Finally, Chapter 11 summarises the main points of the study in a series of numbered propositions and concludes with a brief discussion of potential areas for further theoretical and empirical development of the relationship between inflation and endogenous money. One of the most interesting areas for further research is the issues raised by the analysis of this book for small, open economies with free international capital movements. As is well known, the transmission mechanism of monetary policy for such economies often operates through exchange rate movements rather than interest rate movements, which may make a domestic credit-induced inflationary bubble particularly difficult to restrain using only restrictive monetary policy. This may explain difficulties experienced in the late 1990s by Southeast Asian countries and raises important questions about the role of asset prices in monetary policy more generally (see, for example, the discussion in Gertler et al., 1998).

2 What is money?1

In 1892, Karl Menger published a famous paper ‘On the origin of money’, in which he argued that money is ‘the spontaneous outcome, the unpremeditated resultant, of particular, individual efforts of the members of a society, who have little by little worked their way to a discrimination of the different degrees of saleableness in commodities’ (p. 77). The widespread adoption of the precious metals as media of exchange, for example, was because ‘their saleableness is far and away superior to that of all other commodities’ (p. 80), where Menger defined ‘saleableness’ as the ‘facility with which they can be disposed of at a market at any convenient time at current purchasing prices’ (p. 72). Although the origin of money was therefore a social, and not a state institution, this did not deny the need for a public monetary authority, and Menger concluded his theory with a powerful analogy: ‘by state recognition and state regulation, this social institution of money has been perfected and adjusted to the manifold and varying needs of an evolving commerce, just as customary rights have been perfected and adjusted by statute law’ (p. 82). One factor that is universally recognised as interfering with the efficiency of the institution of money is high and variable rates of inflation. In line with Menger’s last point, monetary authorities around the world have been given mandates to implement policies designed to maintain some measure of price stability, which is the starting point for this book. In approaching this task, however, we must recognise that the institution of money has continued to evolve since Menger’s time through the spontaneous actions of firms and individuals pursuing their own self-interest – particularly as the result of new banking practices and modern technologies for EFTPOS (electronic funds transfer at the point of sale). This has created new challenges for monetary theory, which have been developed in the economics literature using a number of fundamentally different conceptual frameworks. The purpose of this chapter is to review these conceptual differences. Thus the chapter begins with the classical concept that money is a special commodity used in exchange, either in the form of a precious metal or as a fiat currency issued by the state. Within this framework, the monetary authority is able to maintain price stability relatively easily by controlling the quantity of the commodity acting as money. The next section then introduces two influential books written on either side of the Atlantic (Fisher, 1911; Keynes, 1930) that

What is money?

17

weakened the sharp distinction previously observed between ‘money proper’ and ‘money substitutes’ such as bank deposits. This development gave rise to a definition of money as the aggregate of all generally accepted media of exchange, including (some) financial liabilities of commercial banks, which has created an ongoing debate about whether the ability of the banking system to create media of exchange is constrained by the supply of bank reserves (implying a key role for the central bank) or by the demand for deposits (suggesting ‘free banking’ would be more efficient). The third section of the chapter is structured around the seminal article of Black (1970) in which there is no medium of exchange, but the means of payment is provided by the banking sector’s accounting system that records changes in each individual’s holdings of financial assets as a result of trading. Such a pure credit system has no quantity of money per se, and so finance theory is required to understand the transmission mechanism of monetary policy. This third section paves the way for a more detailed discussion of endogenous creditmoney in Chapter 3 and provides the basic framework of analysis used in the remainder of this book. Money is a special commodity of exchange The core general equilibrium model of neoclassical economics is defined over a set of (say) n commodities. Clower (1967: p. 5) provides the standard definition for one of those n commodities to be interpreted as money: ‘A commodity is regarded as money for our purposes if and only if it can be traded directly for all other commodities in the economy’. Thus, in Clower’s famous aphorism, ‘money buys goods and goods buy money, but goods do not buy goods’ (ibid.). The introduction to this chapter has already discussed Menger’s theory on the origin of money; more generally, the essential explanation provided for why certain commodities become money is that ‘the information and transactions costs associated with their use in exchange is lower than that of other goods’ (Gramm, 1974: p. 127; see also Ostroy, 1973; Jones, 1976; Kiyotaki and Wright; 1989; Clower, 1995). Further, once the scales have tipped towards one particular medium of exchange, Greenfield and Rockoff (1996) use Schelling’s (1978) model to argue that this social choice of money will be stable in normal circumstances. The major shortcoming of a money system that uses a physical commodity such as gold or silver is that it takes the commodity away from alternative uses in production (Johnson, 1969a) and so the money is costly to produce. Therefore, as Whitaker’s (1979: p. 354) essay on commodity money observes, ‘an ideal fiatmoney, with its wider choice of feedback rules...and its negligible resource cost, will always be superior to any commodity-money arrangement’ (see also Fischer, 1986). Described by Freeman and Huffman (1991: p. 661) as ‘unbacked, intrinsically useless pieces of paper issued by the government’, fiat-money is easily incorporated into general equilibrium theory by treating it as a new commodity (commodity n + 1) supplied at negligible marginal cost to replace the previous medium of exchange, particularly in overlapping generations models (Samuelson, 1958), as a cash-in-advance constraint on transactions (Clower, 1967;

18

What is money?

Lucas and Stokey, 1973) or as an argument in consumer utility functions (Hicks, 1935; Patinkin, 1965). This concept of money strictly categorises all bank deposits as non-money, since deposits are not commodities but are a form of ‘intermediated capital’ (Freeman and Huffman, 1991: p. 646). It is recognised, of course, that the transactions services of deposits can act as a close substitute for money (Fama, 1982) – and can therefore affect both real-money demand (White, 1984a, p. 709) and the velocity of circulation (Bordo and Jonung, 1987) – but this literature argues strongly that it is a mistake to model money-substitutes as part of the money supply itself (Fama, 1980: p. 54). 2 Within such a framework, the primary responsibility of the monetary authority is to ensure that the quantity of fiat-money on issue meets the needs of commerce without allowing inflation. That is, given that bank deposits are not a perfect substitute for fiat-money, the monetary authority can and should set the nominal supply of fiat-money against its real demand to maintain price stability (Fama, 1980; 1982; 1983; Hall, 1986; Dotsey, 1988; Boschen, 1990; Sumner, 1993). A particularly sophisticated example of how this might be carried out is McCallum’s (1984; 1987) proposed rule for the quarterly growth rate of the money base, which would depend on the average growth rate of base money income velocity over the previous four years and a feedback adjustment in response to departures of nominal output from a target path. Notwithstanding the substantial bank deregulation that has occurred, simulations by McCallum (1988) for the United States and by Haldane et al. (1996) for the United Kingdom suggest that implementing this rule would have produced average inflation of ‘essentially zero’ and ‘less than 2 per cent’, respectively, without creating any significant output variability. The essential feature of this first framework is that money is conceptualised as a distinct commodity whose quantity can be controlled to maintain price stability. This simple and clear-cut result begins to break down, however, if non-commodity assets such as bank deposits are treated as a perfect substitute for cash as a medium of exchange. Money is all generally accepted media of exchange Fisher’s Purchasing Power of Money (1911) provides an authoritative illustration of how financial assets such as bank deposits came to be incorporated on the supply side of many modern money market models. In accord with the theory just discussed, Fisher (1911: p. 11) described two kinds of real money: ‘primary money’ (the chief example of which is gold coin) and ‘fiduciary money’ (the chief example of which is bank notes). But ‘while a bank deposit transferable by check is included as circulating media, it is not money’ (ibid., emphasis added). This distinction was carried over into Fisher’s famous equation of exchange analysis that nevertheless combined bank deposits with actual money in its analysis of influences on the price level:

What is money?

19

The analysis of the balance sheet of banks has prepared us for the inclusion of bank deposits or circulating credit in the equation of exchange. We shall still use M to express the quantity of actual money, and V to express the velocity of its circulation. Similarly, we shall now use M’ to express the total deposits subject to transfer by check; and V’ to express the average velocity of circulation [of these bank deposits]. The total value of purchases in a year is therefore no longer to be measured by MV, but by MV + M’V’. The Equation of exchange, therefore, becomes: MV+ M’V’ = ∑pQ = PT. (Fisher, 1911: p. 10) Note that Fisher multiplied each of his two components of the circulating media by its own velocity, but it is a very short step from this to combine them into a single definition for the money supply, and this step was taken in Keynes’s Treatise on Money. Again following orthodox analysis, the Treatise on Money carefully distinguished ‘bank money’ from ‘money proper’ (1930: p. 5), with the former excluded from the latter because it is more accurately an ‘acknowledgement of debt’. However, Keynes then argued that: One of the fundamental elements in the theory of money is the total quantity of money of all kinds in the hands of the public; and it often makes but little difference whether the money in question is State money or bank money. The aggregate of both may be called current money. (1930: p. 8) Thus, Keynes defined ‘current money’ as the aggregate of all generally accepted media of exchange, including bank deposits, and this practice continues to be widely practised. Such a hybrid concept poses difficulties, however, not the least of which is determining which financial institution liabilities should be treated as generally accepted media of exchange and which should not (Laidler, 1969). This is an essential step if the quantity theory of money is to be applied to this broader definition of the money supply. One approach includes as money only those bank balances held for transactions purposes. Newlyn (1964: p. 335), for example, proposed that ‘the monetary quality consists in the ability to exercise the purchasing power which the assets represent, by right, without penalty or delay’ which would therefore include ‘any form of “call” loan but not any period loan’. Similarly, the monetarist research programme of Brunner and Meltzer (1963; 1972; 1981) defined money as currency plus bank deposits, and modelled time deposits as a non-money financial asset in the credit market. An often-cited study by Pesek and Saving (1967) insisted that only demand deposits should be treated as money, although for reasons that were soon discredited (Friedman and Schwartz, 1969; Johnson, 1969b; Marty, 1969; Patinkin, 1969). As late as 1977 an extensive survey by Feige and Pearce could state simply that ‘the conventional measure of “money” [is] currency plus demand deposits’ (p. 443). Feige and Pearce’s (1977) survey also summarised attempts to define money by the degree of substitutability between different assets. As Marty (1961: p. 60)

20

What is money?

explained, ‘it would be appropriate for the authorities to operate on those assets among which the degree of substitutability is high and which stand in a relationship of complementarity to the remaining financial assets.’ Feige and Pearce supported this approach with a finding that ‘point estimates of cross-elasticities between money [i.e., currency and demand deposits] and near-monies are surprisingly consistent and display relatively weak substitution effects’ (1977: p. 462). Boughton (1981) and Husted and Rush (1984) confirm this conclusion, although more recently a study by Fleissig and Swofford reports that ‘cash assets, savings deposits, and small time deposits are all substitutes for each other’ (1996: p. 372). In contrast, Friedman and Schwartz’s (1963; 1970) path-breaking study of American monetary history concluded that transactions balances was too narrow a definition for money. After paying careful attention to the various theoretical arguments (including the merits of the commodity approach discussed above; see especially pp. 87–198 of their 1970 volume), these two scholars argued that ‘the selection of a specific empirical counterpart to the term money seems to us to be a matter of convenience for a particular purpose, not a matter of principle’ (1970: p. 91). They then provided an extended empirical defence of their chosen definition which included time and saving deposits, as well as the more traditional demand deposits of commercial banks. A similar conclusion was reached by an alternative approach based on the concept of liquidity (see Keynes, 1936: Chapters 13 and 15). As Hicks put it in his 1962 Presidential Address to the Royal Economic Society, this approach assumes ‘a sharp line between money, the capital value of which is certain (in money terms), and “risky securities,” the capital value of which is quite uncertain’ (1962: p. 795; see also Tobin, 1958; Runde, 1994). All bank deposits – including saving and time deposits – are perfectly liquid and so should be treated as money, and indeed Miller (1984) notes that this was the practice of Keynes himself. In Britain, liquidity became a fundamental concept in the famous Radcliffe Report, as the following quotation illustrates: Given this approach, regulation of banks is required not because they are ‘creators of money’ but because they are the biggest lenders at the shortest (most liquid) end of the range of credit markets. Any severely restrictive control of their operations is certain, over a period of time, to be defeated by the development of rival institutions; during the interim, the community will have suffered loss by interference with the most efficient channels of lending. (Committee on the Working of the Monetary System, 1960: ¶504) More recently, a third approach to defining the money supply has challenged the rigid distinction between money and non-money assets. Barnett (1980) has argued that Divisia indices should be calculated based on econometric estimates of the importance of each financial asset in providing money services (see also Barnett et al., 1984). This has led to a growing number of papers constructing composite monetary aggregates for different countries using the Divisia technique (see, for example, Serletis and Robb, 1986; Barnett et al., 1992; Mullineux, 1996; Fisher

What is money?

21

and Fleissig, 1997), but this literature does not appear to have had any strong impact on monetary policy to date. During the 1970s and early 1980s many central banks announced money supply targets using whatever narrow or broad monetary aggregate appeared to have the most reliable econometric relationship with nominal gross domestic product (GDP) in each country. Most countries, however, found that even previously robust empirical relationships soon broke down (Germany and Switzerland were important exceptions), confirming Goodhart’s law that ‘any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes’ (Goodhart, 1975: p. 96). This turned attention back to controlling the monetary base – that is cash plus any other central bank liabilities held as reserve assets within the banking system – not because other assets were considered not to be money (as in the previous section of this chapter), but because the supply of base money was considered to be an ultimate constraint on the banking system’s ability to expand nominal money balances (see, for example, Friedman, 1969; Freeman, 1986; Cagan, 1987; Dowd, 1994b; Selgin, 1994). One way to interpret this framework is to regard the monetary authority and the commercial banks as engaged in a joint venture of meeting the economy’s demand for real money balances. Dwyer and Saving (1986: p. 239), for example, suggest that ‘the government can be considered as the holder of a patent on money’ who provides licences ‘to private issuers of money for a fee’ (namely, the seigniorage on reserves – see also Freeman, 1987, who argues that it would be more efficient to tax bank deposits directly). A well-developed example of this interpretation is the ‘limited participation’ theory of Grossman and Weiss (1983), Rotemberg (1984), Fuerst (1992; 1995), Chari et al. (1995) and Christiano et al. (1996). In this theory, an injection of base money into the banking system creates an excess supply of reserves that banks use to create new money balances for their customers. Those agents who are participating in the money market at the time of the expansion must be persuaded to absorb a disproportionate share of the new funds (creating liquidity effects) whereas those who are not find the real value of their money holdings reduced as a result of the consequent inflation (lowering their real consumption). Thus the model can produce persistent real effects from monetary policy, based on the idea that the constraint on bank-initiated money expansion comes from the supply of reserves determined by the monetary authority. 3 Another approach, however, argues that the restraint on money expansion comes not from the supply-side (that is from the quantity of bank reserves provided by the central bank) but from the demand-side (that is from the willingness of customers to hold bank deposits) through the ‘law of reflux’. This theory has been summarised by Glasner (1992: p. 869) in the following terms: ‘What the law of reflux asserts is that private banks cannot create an inflationary overissue, because there is a market mechanism that induces banks to supply just the amount of money that the public wants to hold.’ Such a view has a long history in economics (as Glasner’s article attests; see also Lavoie, 1999), but its modern restatement is normally attributed to Tobin:

22

What is money?

Evidently the fountain pens of commercial bankers are essentially different from the printing presses of governments. ... For bank created money, there is an economic mechanism of extinction as well as creation, contraction as well as expansion. If bank deposits are excessive relative to public preferences, they will tend to decline; otherwise banks will lose income. (1963: p. 278) Black (1972: p. 812) elaborates: ‘If a bank issues money to make a loan to one person and that money is more than the public wants to hold at equilibrium interest rates, then it will simply be used to pay off another loan, at the same bank or at another bank.’ This theory that deposits adjust in line with customer demand has strong implications for the overall money supply. In the real business cycle model of Kydland and Prescott (1982), for example, changes in output are produced by stochastic shocks to technology and productivity, propagated over time by intertemporal substitution decisions. King and Plosser (1984; 1987) argue that these shocks also affect bank deposits. In their model, this explains the strong correlation between total money supply and output, but in contrast to most textbook discussions there is no causal relationship from money changes to the business cycle (see also Boschen and Mills, 1988; Freeman and Huffman, 1991; Fuerst, 1995; Farmer, 1997). As Hoover (1991: p. 383) observes to his own surprise, this result resuscitates the 1970s Keynesian theory that an endogenous money stock prevents the use of monetary aggregates, however defined, for controlling inflation (Kaldor, 1970; Robinson, 1970; Tobin, 1970; Davidson, 1972; Weintraub and Davidson, 1973). Indeed, some post-Keynesians argue that the banking system will supply as much credit-money as is demanded at whatever interest rate is fixed by the central bank (Kaldor and Trevithick, 1981; Moore, 1988c; Lavoie, 1996), but this ‘horizontalist’ position has generally given way to liquidity preference models in which an increase in the broad money supply typically requires a higher interest rate on loans to offset the banking sector’s loss of liquidity (Wray, 1990; Cottrell, 1994b; Hewitson, 1995; Arestis and Howells, 1996; Dow, 1996a). This literature will be considered in more detail in the following chapter, but note its major implication that increases in the monetary base cannot cause inflation since the volume of credit-money created by the banking system always adjusts passively to ensure total money supply does not exceed total money demand. 4 One of the major outcomes of the research presented in this book is to challenge that result. Based on the demand-side theory of bank restraint, there is a substantial body of literature that argues all money should be competitively supplied in a system of ‘free banking’, without any role for a state-sponsored central bank (see, for example, Klein, 1974; Hayek, 1978; Dowd, 1989; 1996; Selgin, 1988; 1994; Selgin and White, 1987; 1994; White, 1993). Indeed, this literature hypothesises that free banking would have evolved naturally had it not been for the interference of governments requiring inflation-tax finance for their expenditures (Smith, 1936; White, 1984b; Dowd, 1994a); Goodhart (1988) presents a contrary argument. An important element in the free banking proposal is the hypothesis that ‘to attract

What is money?

23

ultimate wealth holders faced with a choice of monies, banks would have to issue monies convertible into real assets to assure money holders against capital loss’ (Girton and Roper, 1981: p. 27). This would require every form of currency in circulation to be brand-identified (Klein, 1974; Saving, 1976), but otherwise the market could be left to determine its own assets of redemption and clearing-house institutions (Timberlake, 1984). If any individual bank overissued its money liabilities, it would lose quantities of the redemption asset to rival banks (a process Selgin, 1988: pp. 40–2, calls the ‘principle of adverse clearings’). If the banking system as a whole overexpanded, the public would return the excess money and so drain the system of its reserve asset (Selgin, 1989). 5 Thus, there is a sharp division within this framework between those who consider that banks as creators of money must be constrained on the supply-side by the monetary authority and those who consider the constraint comes from the banks’ customers on the demand-side without any need for central bank interference. In the third framework considered in this chapter, the two sides of the banking system’s aggregate balance sheet are brought together in a finance theory of money. Money is a financial asset The first extensive analysis of money within finance theory was undertaken by Gurley and Shaw (1955; 1956; 1960). These authors introduced the term ‘inside money’ to describe media of exchange created by financial intermediaries (1960: p. 73), and argued that an important characteristic of inside money is that its total value is exactly matched by the aggregate liability of bank advances (in contrast to ‘outside money’ supplied by the state, which has no offsetting liability). If the price level rises, therefore, the reduction in real wealth experienced by inside money holders is offset by the increased real wealth of bank borrowers, and so the net wealth effect of the higher price level on aggregate demand is weak, and perhaps zero (depending on distribution effects). Consequently, Gurley and Shaw argued that free banking produces an indeterminate price level, unless the central bank has some minimum regulatory powers over the banking system. Like some of the scholars surveyed in the previous section, this would require that the central bank set the quantity of bank reserves, but in keeping with finance theory, the yield of bank reserves must also be fixed. Patinkin generalises their result as follows: ...in the absence of distribution effects, the necessary conditions for rendering a monetary system determinate is that there be an exogenous fixing of (1) some nominal quantity and (2) some rate of return. It follows that if we were to extend the argument to an economy with both inside and outside money...it would suffice to fix the quantity of outside money and its rate of return (say, at zero). (1961: p. 116)

24

What is money?

Within this finance framework, monetary policy does not operate by exogenously restricting the supply of some commodity called ‘money’ (or perhaps ‘base money’), but by altering interest rates that then affect portfolio choices among financial assets including the endogenous creation of inside money balances (Brunner and Meltzer, 1963; Tobin and Brainard, 1963; Tobin, 1969; Foley and Sidrauski, 1970; Miller, 1980; Walsh, 1982). This is no simple matter, however, since ongoing financial innovation that creates new monetary instruments and reduces the need for bank reserves makes the transmission mechanism of monetary policy very fluid compared with rules based on the quantity theory of money (Tobin and Brainard, 1963; Wojnilower, 1980; Minsky, 1982; Podolski, 1986; Ireland, 1995). Indeed, it is possible to imagine a world in which there is no need for any specific medium of exchange, but the means of payment is provided by bookkeeping entries that track changes in ownership of financial assets arising from economic trades. If, for example, agent A purchases an item from agent B, this transaction can be settled by a cheque or EFTPOS instruction subtracting the item’s price from A’s bank balance and crediting it to B’s account, without the need for any explicit medium of exchange. In a remarkably prescient paper, Black (1970) recognised that money in the classical sense would not exist in such a world, but the word ‘money’ could be used as ‘short for “means of payment” without meaning to imply that a quantity of money exists’ (Black, 1970: p. 14). Without a quantity of money, neither the quantity theory of money nor the theory of liquidity preference applies, and so the price level and the inflation rate are indeterminate (a proposition Black held was true in the real world as well as for his imaginary one; see Black, 1986: p. 540; 1995: p. 80). For some theorists, Black’s price indeterminacy result simply confirms the critical role played by currency, along the lines explained in the first section above (see especially Fama, 1980; 1983). Alternatively, Hall (1982) proposed that the price level could be established by defining a non-monetary unit of account; in particular, Hall proposed ‘a resource unit [called] the ANCAP comprising 33 cents worth of ammonium nitrate, 12 cents worth of copper, 36 cents worth of aluminum, and 19 cents worth of plywood (all in 1967 prices) [which] had a market value very close to the cost of living throughout the postwar era’ (1982: p. 115). Bringing these ideas together, Greenfield and Yeager (1983; 1986) put forward a BFH model (after Black, Fama and Hall), in which the ‘the idea is to define the unit of account physically, in terms of many commodities, and not in terms of any medium of exchange’ while ‘the government would practice laissez-faire toward the medium of exchange and the banking and financial system’ (1983: p. 303; see also Yeager, 1985; Woolsey, 1994; Selgin and White, 1994; 1996). ‘New monetary economies’ (as this paradigm came to be called – see Cowen and Kroszner, 1987; 1994; Hoover, 1988) raises an important issue about how a free banking system would sustain convertibility if the unit of account is defined in terms of ‘a nearly comprehensive bundle of goods and services’ (Woolsey, 1992: p. 265). The most common proposal is for financial institutions to offer ‘indirect convertibility’, under which each bank would back its issue, not with the

What is money?

25

specific items in the defining bundle of goods but with some convenient ‘medium of redemption’ (perhaps gold or platinum) at a fluctuating price equal in market value to the unit of account. Several authors argue it is not practical to separate the unit of account from the medium of exchange (White, 1984a; 1986; McCallum, 1985; Cowen and Kroszner, 1987; Selgin and White, 1987) and the proposal is also criticised as being unsustainable in the presence of shocks to the market price of the medium of redemption (the so-called ‘paradox of indirect convertibility’; Schnadt and Whittaker, 1993; 1995; Cowen and Kroszner, 1994: Chapter 3). Neither criticism is accepted by proponents of the scheme, who argue for example that the potential for large losses identified in the paradox is precisely the incentive needed for banks to ensure that the value of their media of exchange remains stable (Woolsey and Yeager, 1994; Greenfield et al., 1995; Dowd, 1995). 6 Another branch of the literature offers a solution to the price indeterminacy result by denying that it is a problem. Rose explains in the context of a general equilibrium growth model: It has been objected that the price level is thereby rendered ‘indeterminate’. We admit this, but deny that it constitutes an objection. All the state variables of the system, real income, capital, etc., are indeterminate in exactly the same sense. Nevertheless their time paths are uniquely determined once their initial values have been given. So is that of the price level. (1969: p. 148, fn. 5) The basic assumption behind Rose’s argument is that the average price of goods and services will rise if there is excess demand in the economy and will fall if there is excess supply. Thus the time path of the price level is endogenously determined by the history of aggregate demand compared with the economy’s supply-side capacity, and so price stability requires that monetary policy be used to keep the former as close to the latter as is possible. This framework is frequently termed ‘Wicksellian’ after Knut Wicksell’s (1907; 1935; 1936) ‘pure credit system’, which is widely credited as the first to explore these issues in a model with no currency. 7 Wicksell’s model was a classical analysis of the market for loanable funds in which the ‘natural rate of interest’ was defined as ‘the rate of interest at which the demand for loan capital and the supply of savings exactly agree, and which more or less corresponds to the expected yield on the newly created capital’ (Wicksell, 1935: p. 193). If the banking system offered a rate of interest below this natural rate, this would increase consumption demand at the same time as the supply of consumption goods fell (due to increased production of investment goods), and so the price level would rise (idem: p. 194). Thus Wicksell argued that credit-money created by the banking system is able to cause inflation by pushing the prevailing rate of interest below its natural rate, which led to his policy rule as follows: This does not mean that the banks ought actually to ascertain the natural rate before fixing their own rates of interest. That would, of course, be impracticable,

26

What is money?

and would also be quite unnecessary. For the current level of commodity prices provides a reliable test of the agreement or diversion of the two rates. The procedure should rather be simply as follows: So long as prices remain unaltered the banks’ rate of interest is to remain unaltered. If prices rise, the rate of interest is to be raised; and if prices fall, the rate of interest is to be lowered; and the rate of interest is henceforth to be maintained at its new level until a further movement of prices calls for a further change in one direction or the other. (Wicksell, 1936: p. 189, emphasis in the original) Building on this framework, Rose (1966; 1967; 1969) and Stein (1966; 1968; 1969) presented models with separate behavioural equations for investment and saving in which inflation was proportional to any excess of the former over the latter (Hadjimichalakis, 1981, provides a good overview). The earliest models produced by this research were all vulnerable to Friedman’s (1968: p. 8) critique that ‘Wicksell’s analysis failed to distinguish between nominal and real interest rates’, since although investment and saving depended on expected inflation (and hence on the real interest rate) persistent inflation required an ongoing excess demand in the goods market. Stein (1970: p. 105; 1971) suggested this could be remedied by making inflation a function of expected inflation as well as the gap between investment and saving (see also Fischer, 1972; Boggess, 1983), but the model then produced very similar steady-state properties to its neoclassical counterpart, and subsequent interest in this line of research appears to have faded away. 8 More recently, interest in the original Wicksellian model has been revived. Simple mathematical treatments of Wicksell’s model have been provided by Eagly (1974: pp. 84–9), Bailey (1976), Honohan (1981), Gootzeit (1988) and Humphrey (1990); while Humphrey (1992), Fuhrer and Moore (1995) and Woodford (1995; 1998) have recently used some version of Wicksell’s model to defend a monetary policy regime based on using interest rate changes to aim for some target inflation rate (perhaps zero) rather than Wicksell’s original target of price level stability. This policy rule is, of course, very close to actual monetary practice in many OECD countries (Fuhrer and Moore, 1995: pp. 1060–1; Woodford, 1998: p. 175), and Chapter 10 will derive a similar rule within the finance framework of this book. Conclusion This chapter’s review of the theoretical development in the approach of economists to money suggests that this development is being driven by changes in the practice of banking. Chick (1993a), for example, has argued that there have been six stages in the evolution of banks, from the earliest days in which banks were numerous, geographically semi-isolated and dependent on local depositors for reserves, to the current situation where banks are relatively few in number and all operate within a fully integrated global system that allows them to manage both their asset

What is money?

27

and their liability structures at market-determined interest rates. Chick further argues that this evolution in banking practice has profound implications for the theory and practice of monetary policy. It has, for example, been a major driving force in the evolution of the ‘means of payment’ from the simple commodity medium of exchange surveyed in the first section of this chapter, to the hybrid concept that included some bank liabilities considered in the second section, to the bookkeeping system of changing financial balances surveyed in the third section. The first of the three frameworks is undoubtedly the simplest for monetary policy. If a particular commodity is the economy’s unique medium of exchange, then the monetary authority has the easy task of controlling its quantity to maintain stability in the general level of prices. Once financial liabilities created by the banking system are also generally accepted to settle transactions, however, monetary policy is complicated by Johnson’s observation that ‘a competitive banking system [is] under constant incentive to expand the nominal money supply and thereby initiate price inflation’ (1968: p. 976). Within this second framework, there is an ongoing debate about whether this incentive must be constrained by a central bank restricting the supply of reserves to the banking system or whether it is constrained by the quantity of bank deposits bank customers are willing to hold (the law of reflux). Within the third framework, finance theory analysing the balance sheet activities of the banking system draws attention to the role played by the base interest rate in controlling the growth of aggregate demand relative to supplyside capacity growth. An interesting feature of this third framework, compared with the alternatives considered in this survey, is that it produces a policy rule that is very close to current monetary policy practice. Chick (1993a: p. 91) concludes from her analysis that ‘the theory of monetary policy has not developed to keep pace with institutional change’ and finishes with the rhetorical question: ‘What is to be done?’ The survey in this chapter is able to suggest an answer. If modern banking developments mean that for most relevant purposes economic transactions are now settled through the financial sector’s balance sheet accounting system rather than through transfers of an explicit medium of exchange, then future theoretical developments are likely to take place within finance theory rather than being based on the quantity theory of money. This is the approach taken in this book, and so Chapter 3 considers in more detail how the banking system is able to create credit-money.

3 Credit-money and inflation

The previous chapter has described the important role of the banking system in supplying a nation’s medium of exchange. In February 1999; for example, the United Kingdom’s broad money supply (M4) was valued at £782.8 billion, of which only £22.6 billion was notes and coins held by the public. The remaining 97 per cent was made up of bank deposits created by financial institutions. There is a long-standing debate in the literature about whether this ‘credit-money’ (as bank deposits are often called, to distinguish them from ‘commodity money’ or ‘fiat-money’ issued by the state) can cause inflation, or whether it is always endogenously supplied by the banking system in response to demand. This chapter therefore explains how financial institutions create money, and examines the argument that credit-money expansion is always the result and never the cause of changes in the nominal value of economic transactions. 1 This second task is particularly important, since the remainder of the book will derive a contrary model in which the funding decisions of firms create the economy’s stock of money in a way that can be inflationary unless disciplined by the central bank. The process of money creation Keynes (1930: p. 3) defined money as the object ‘by delivery of which debt contracts and price contracts are discharged, and in the shape of which a store of general purchasing power is held’. In modern economies, there are two forms in which general purchasing power can be held: currency (that is banknotes and coins) and bank deposits (that is credit balances in financial institution accounts). There are important similarities between these two forms – in particular, both are produced by balance sheet transactions within a country’s finance system – but there are also some significant differences. Currency is issued by a monopoly supplier (the country’s central bank), for example, whereas bank deposits are created by a diverse range of competitive financial institutions. Once issued, currency cannot be retired without a decision by the central bank to redeem its liabilities, whereas bank deposits can be reduced by their holders using them to repay bank loans (the law of reflux, pp. 21–22 above and pp. 33–37 below). Currency also plays a unique role in the finance system that gives the central bank its leverage over the conduct of member financial institutions, which will be discussed in this book’s analysis of monetary policy in Chapter 10.

Credit-money and inflation

29

Money creation begins with the central bank arranging for the printing of banknotes and the minting of coins (in some countries, including the United Kingdom, the Treasury has responsibility for coins, but this does not affect the analysis in any material way). Although this physically creates currency, the money does not enter into circulation until the central bank uses it to purchase something. The accepted practice is to buy financial assets, that is some combination of government and private sector securities. In the United Kingdom, this is the responsibility of the Bank of England’s Issue Department and produces a balance sheet transaction recording the government and other securities as its assets and the currency on issue as the department’s only liability – see Table 3.1. Creating money in this way (known as seigniorage) is very profitable, since the central bank receives the market rate of interest on its holdings of the purchased financial assets, but it does not pay interest on its currency liability (and incurs no other costs apart from the comparatively insignificant expense of producing and issuing the currency). For example, seigniorage provided the Bank of England with net revenue amounting to £1.7 billion in its 1998/9 financial year (payable to the United Kingdom Treasury), and this is one reason why governments reserve the power of currency creation to themselves. Consider now Table 3.2, which contains a typical balance sheet for a major financial institution (Barclays PLC). The major liability of this institution is ‘Deposits by customers’. Because bank deposits are able to act as the medium of exchange for their holders, they are included in the definition of the country’s broad money supply. Table 3.2 reveals that the deposits at this single bank is more than four times the total value of banknotes issued by the Bank of England, and this predominance of bank deposits over currency held by the public explains why modern central banks do not have direct control over the aggregate money supply. It also suggests why policymakers must rely on indirect measures that influence bank behaviour (through changes in the base interest rate; see Chapter 10) in order to maintain monetary discipline. The fundamental characteristic of financial institutions that allows them to create bank deposits in excess of the currency on issue is their ability to grant loans (the fourth item on the assets side of Table 3.2) in a form that is then able to act as medium of exchange. In other words, just as the central bank’s key transaction is the use of printed banknotes to purchase public or private securities, so the key transaction for financial institutions is the granting of a bank loan that is then redeposited back into the finance system. An example will serve to Table 3.1 Bank of England Issue Department balance sheet as at 28 February 1999

Source: Bank of England Annual Report, 1998/99, p.84.

30

Credit-money and inflation

Table 3.2 Barclays PLC consolidated balance sheet as at 31 December 1998

Source: Barclays PLC Annual Report, 1998, pp. 100–101. Notes All balance sheet items involving other banks have been netted out of the accounts. Accrued payments is net of accrued income. Shareholders funds include minority interests of £314 million.

illustrate. Suppose a bank allows a customer firm to borrow £100,000 to purchase new machinery. When the firm draws down the loan, the bank’s balance sheet records two changes. First, the value of ‘Loans to customers’ increases by the value of the loan. Second, the value of ‘Deposits by customers’ also increases by £100,000, as the loan is initially held in the borrowing firm’s cheque account. This increase in bank deposits is ‘new money’, which can be used by the firm to pay the supplier of its new equipment. In subsequent transactions, this new money circulates through the financial sector, passing from bank to bank as cheques are drawn on an account of one institution and deposited in an account of another. This affects individual balance sheets, of course, but in the aggregate total deposits of financial institutions remain unchanged. Hence the money remains in existence, until the original or some other bank loan is repaid. Table 3.3, for example, shows that at the end of December 1998 banks in the United Kingdom had made loans to their customers of £1,890 billion and had accepted deposits of £2,029 billion (although note that a proportion of these figures involved foreign currency rather than sterling). Creating money through bank loans redeposited is not as lucrative as seigniorage, since, unlike the central bank, the financial institutions must pay Table 3.3 United Kingdom banks aggregated balance sheet as at February 1999

Source: Bank of England Monetary and Financial Statistics, September 1999, Table 9.1

Credit-money and inflation

31

interest on the liability they create (the bank deposits). Nevertheless, banking can be very profitable because the finance sector is highly geared (see, for example, Table 3.2). Suppose that Barclays was able to generate a net rate of return on its loans to customers and on its holdings of securities and shares of just 1 per cent (net of all expenses and tax liabilities). This would generate a profit of £1,463 million, which divided by shareholders’ funds (£8,237 million) would allow a dividend payment of 17.8 per cent. This illustrates how a low return on assets in the financial sector can generate a high rate of return for shareholders. This does not mean, however, that the finance sector is able to create money in this fashion without limit; bankers must also take into account three substantial risks when determining the optimal size and composition of their balance sheets. The first risk arises if a bank creates new loans at a faster rate than the rest of the finance system. Such a bank will find itself incurring net obligations to other financial institutions if it does not simultaneously increase its market share of bank deposits. The specific outcome depends on the institutional details of the finance system, but universally the bank growing too fast will incur increased costs. 2 Of course, this does not restrict the aggregate ability of the finance system to expand the money supply, as long as all financial institutions expand their loans at similar rates. The second risk is the possibility of a ‘bank run’ if an individual institution loses the confidence of its customers. A bank run occurs if a large proportion of a bank’s depositors seeks to withdraw cash at the same time, beyond the ability of the bank to meet the demand. For example, at the end of December 1998 Table 3.2 records that Barclays owed its depositors £108,805 million. However, the amount of liquid reserves on hand (the first three assets in the balance sheet) was only £9,078 million. Hence the ratio of liquid reserves to deposits was less than 10 per cent, showing the bank’s vulnerability if a sufficiently large number of depositors attempted to withdraw cash at one time. The lower the ratio of liquid reserves to deposits is, the greater the risk is; and so all banks must maintain a prudent ratio between their liquid reserves and the likely demands of their depositors. Many modern theories of monetary economics are founded on the assumption that this requirement for a prudent reserves ratio allows the monetary authorities to determine the aggregate money supply by controlling the quantity of liquid reserves made available to the financial sector. Suppose, for example, that the public chooses to hold a fixed proportion of its bank deposits, D, in the form of currency, Cp, and that the banking system has adopted a fixed reserve ratio between its cash balances, CB, and its deposits. Let cu be the public’s ratio of currency to deposits, and let re be the banks’ reserves ratio. The aggregate money supply, M, is defined to be the sum of cash held by the public plus the bank deposits. Thus: M = CP + D

(3.1)

Cp = cu.D

(3.2)

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Credit-money and inflation

D = CB/re

(3.3)

M = [(1 + cu)/re]CB

(3.4)

Equation 3.4 suggests a stable multiplier relationship between a country’s monetary base (CB, which can be directly controlled by the central bank) and its money supply (M, including the credit-money created by the banking system). Such an approach may have been plausible when financial institutions were subject to minimum reserves ratios set by regulation, but this is no longer the case and one leading central bank economist, Charles Goodhart, bluntly describes the money multiplier textbook account as ‘absolute baloney’ (Goodhart, 1984: p. 200; see also his comments in 1994: pp. 1424–6). It is extremely unlikely that any central bank would allow a fundamentally sound financial institution under its jurisdiction to fail simply because it lacked sufficient liquid assets during a run on its deposits (especially if this involved a large institution whose failure might have consequences for other banks). 3 Thus modern analysis of the ultimate constraint faced by banks focuses on the risk of bad debts. This possibility of bad debts is the third and most critical risk restricting private sector money creation. Recall the earlier example of the firm borrowing £100,000. Suppose that after paying its supplier, the debtor firm collapsed and moved into receivership. The level of deposit liabilities faced by the lending bank, and by the finance system as a whole, would remain unchanged, but the value of the lending bank’s offsetting asset would depend upon whether the loan’s collateral was sufficient to cover the debt. If not, the resulting bad debt would reduce the bank’s residual item in its balance sheet (that is shareholders’ funds). For example, if the resale value of the collateral supporting the loan turned out to be only £60,000, the bank’s assets on the left-hand side of the balance sheet would fall by £40,000, and so would shareholders’ funds on the right-hand side. Although the high gearing ratio of banks means they are able to generate large rates of return on shareholder funds from a low rate of return on assets, this characteristic also means that a relatively small volume of bad debts can wipe out all shareholder funds, forcing the bank to close. Consider again Table 3.2. The total loans to customers by Barclays at the end of 1998 was £96,110 million whereas its shareholders’ funds were £8,237 million. Thus, if the bad debts net of collateral values turned out to be 10 per cent of total loans, this would be sufficient to absorb all the shareholders’ funds and the customer deposits would be at risk. Of course, bankers are aware of this danger, and so are expected to vet loan applications prudently in order to prevent bad debts on anything like this scale. Nevertheless, the history of banking is peppered with examples of bank failures caused by bad debts as a result of negligence, fraud or some unhedged systematic risk (the collapse of the Barings Group at the end of February 1995 is a recent example). Indeed, the whole financial system can be vulnerable if sufficient members are exposed to a high proportion of bad debts. When Mexico announced in August 1982 that it could not meet overseas debt obligations, for example, many banks in developed countries were exposed to the

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debt of developing countries to an extent well in excess of their capital. As the Bank of England has observed: ‘Thus the crisis was as much one for the lenders as for the borrowers, posing a systemic threat to the world’s financial system’ (Dicks, 1991: p. 498). Thus, the banking system’s ability to create money is ultimately restricted to its ability to find good credit risks supported by adequate loan collateral. Consequently, banking supervisors around the world require member institutions to meet international standards for ‘capital adequacy ratios’, defined as the ratio of capital reserves and shareholders’ funds to the institution’s risk-weighted assets (where the weights reflect the quality of the collateral backing the loans). The intention is that if a bank meets these standards, set by the Basle Committee centred in the Bank for International Settlements, its depositors can be reassured that there is a reasonable buffer to protect them against losses as a result of bad debts, assuming of course that prudent lending practices are maintained and there is no fraud within the bank (see, for example, Folkerts-Landau and Lindgren, 1998). Both ‘exogenous money’ and ‘endogenous money’ theorists accept the above account of money creation. The point of contention concerns whether it allows the monetary authorities to exercise direct control over the aggregate money supply. Exogenous theorists point to the central bank’s ability to determine the level of currency on issue, and to the restraint the supply of currency subsequently places on the finance system’s ability to create credit-money. Thus this view argues that the central bank is always able to determine the aggregate money supply by controlling the monetary base, provided it is given the freedom to do so (for example by not requiring it to fund large or persistent government budget deficits; see Chapter 9). Endogenous theorists, on the other hand, point to the overwhelming importance of credit-money relative to currency-money in the aggregate money supply, and to certain institutional restrictions on the ability of the central bank to use currency restraint as a device for slowing credit expansion. Thus this view argues that central banks are limited in their ability to impose quantitative constraints on the money supply, but instead must rely on changes in interest rates (or perhaps in interest rate spreads) to influence credit growth indirectly. The arguments supporting this endogenous money theory are the subject of the next two sections of this chapter. The law of reflux A useful starting point for a discussion of endogenous money theory is the law of reflux. Recall from the previous chapter that the law of reflux ‘asserts that private banks cannot create an inflationary overissue, because there is a market mechanism that induces banks to supply just the amount of money that the public wants to hold’ (Glasner, 1992: p. 869; see also Tobin, 1963; Black, 1972; Lavoie, 1999). The simplest way to present this ‘law’ is to consider a hypothetical balance sheet for a representative non-bank economic agent (which can be thought of as the government, a firm, a household or an individual). Thus, Table 3.4 shows the agent’s assets on the left-hand side of the balance sheet (listed from most liquid to

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Table 3.4 Non-bank economic agent balance sheet

least liquid), and the agent’s liabilities on the right-hand side. The assets are made up of currency, bank deposits, non-bank financial assets and physical assets, whereas the liabilities are bank loans and non-bank debt. The agent’s net worth is the residual item on the liabilities side which ensures that the two sides of the balance sheet sum to the same value. Suppose that for some reason the agent found that he or she was holding more currency than desired. It would be a simple matter for the agent to restore portfolio balance by depositing the excess cash into a bank account, increasing the value of bank deposits. Similarly, agents are able to draw on their bank deposits in order to meet any shortfall of desired cash. Hence the first component of the broad money supply in Equation 3.1 (that is cash held by the non-bank public) is fully endogenous, as long as the banking system is provided with enough cash to meet demand. The implications of what happens if the proviso is not satisfied (perhaps as the result of a policy decision by the central bank to tighten the financial sector’s liquidity) will be discussed shortly. Similarly, suppose that the agent decides that he or she has an excess amount of bank deposits in his or her portfolio of assets. Although a single agent might seek to eliminate this excess stock of money by offering to purchase non-bank financial assets or physical assets, this strategy cannot succeed for the economy as a whole. This is because for every buyer there must be a seller willing to accept increased bank deposits, so that an aggregate excess supply of money cannot be eliminated by transactions restricted to the asset side of the economy’s balance sheets. There is, however, an alternative – the agent could use the excess money balances to retire some of his or her bank loans on the liabilities side of Table 3.4. This would reduce the agent’s total assets and total liabilities by the same amount (leaving net worth unchanged), and would reduce the economy’s money stock by reducing the aggregate value of bank deposits. This is the law of reflux in action: excess money balances are extinguished by using them to retire bank debt. Similarly, if an agent wished to increase the value of bank deposits in his or her portfolio, this could be achieved by using the physical assets in the balance sheet to act as collateral in order to obtain new bank loans. Indeed, this ability to convert physical assets into liquid currency is a particularly important function of the banking sector, as was well expressed in Fisher’s famous study:

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If the acres of a landowner or the iron stoves of a stove dealer cannot circulate in literally the same way that gold dollars circulate, yet the landowner or stove dealer may give to the bank a note on which the banker may base bank notes or deposits; and these bank notes and deposits will circulate like gold dollars. Through banking, he who possesses wealth difficult to exchange can create a circulating medium. He has only to give to a bank his note – for which, of course, his property is liable – get in return the right to draw, and lo! his comparatively unexchangeable wealth becomes liquid currency. To put it crudely, banking is a device for coining into dollars land, stoves, and other wealth not generally exchangeable. (1911: p.41) So far, this analysis supports the idea that the stock of money adjusts to economic conditions (assuming no interference from the central bank), since any amount of the medium of exchange – whether in the form of currency or bank deposits – can be supplied or extinguished by the financial system in response to changes in demand by the public. This conclusion, however, is subject to two caveats. The first caveat concerns whether banks face any other constraint (that is other than the need for suitable collateral) that might prevent them from increasing the level of advances and deposits. In particular, providing new loans to increase the value of bank deposits would lower the financial system’s ratio of liquid reserves to its customer deposits. This observation has led to a debate in the literature between ‘accommodationists’, who argue that the central bank will always supply extra cash or reserves to restore the financial system’s liquidity, and ‘structuralists’, who argue that the loss of liquidity would need to be compensated for by an increase in the interest rate spread between the bank’s deposits and advances. 4 There are a number of reasons why the central bank might feel obliged to accommodate a credit expansion by providing extra reserves. In an early work on this subject, for example, Weintraub and Davidson (1973) argued that public opposition to the unemployment consequences of monetary restraint would make accommodation politically inevitable (see also Gedeon, 1985; Lavoie, 1985a; Arestis and Howells, 1992). More commonly it is argued that the role of the central bank as protector of the overall financial system means it is obliged to act as lender of last resort whenever the system needs more liquidity, and so the monetary authorities cannot continuously use reserve asset constraint to control credit expansion (Moore, 1979; 1988b; 1989a; Kaldor, 1982; Lavoie, 1985b; Arestis, 1988: p. 47; Pollin, 1991). For some writers – notably Nicholas Kaldor, Marc Lavoie and Basil Moore – this second consideration removes all reserve constraints on bank lending, so that they argue there are no supply-side restrictions to money creation. In their theory, the money supply function (if such a concept is meaningful when there is no supply without demand; see, for example, the debate between Moore, 1997, and Howells, 1997) is a horizontal line at the rate of interest determined by the monetary authorities. Other writers have explicitly rejected this claim, arguing instead that the central bank will not always fully accommodate an increased demand for cash or

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reserves, since policymakers are also under political pressure to control inflation (which in many countries is now enshrined in legislation as the sole objective of monetary policy) and so will tolerate rising unemployment if it helps stabilise prices. Nevertheless, the structuralist approach also argues that even if the central bank does limit reserves, there are ways for banks to relax this constraint, especially through financial innovation (see, for example: Minsky, 1957; 1982; Wojnilower, 1980; Dow and Earl, 1982: Chapter 7; Chick, 1984; 1986; 1993a, b; Evans, 1984; Arestis, 1988: p. 65; Pollin, 1991). This allows the financial sector to increase the volume of credit-money in response to higher demand, but at a greater cost than if reserves were more freely available. This greater cost must be reflected in a higher interest rate, and so this approach argues that the credit-money supply function is not horizontal, but is positively sloped (see especially Dow, 1996a: Figures 1–4). Marc Lavoie (1996; 1999) suggests that the difference between these two approaches is more a matter of emphasis than of substance. Some writers in the accommodationist tradition, for example, have recognised that policymakers might choose to raise their base interest rate if called upon to provide extra reserves, and this would trace out ‘a dynamic upward-sloping supply curve of loans’ (Lavoie, 1996: p. 280). Similarly, some writers in the structuralist tradition have recognised that at least over a certain range, the supply of credit can be thought of as ‘equivalent to the horizontalist supply of credit curve’ at the central bank’s base interest rate (Dow, 1996a: p. 502). Perhaps most importantly, both sides recognise that there are potential liquidity costs to banks if they increase the money supply on demand, and that these costs can be offset by the central bank accommodating the induced demand for extra reserves. Thus, all can agree that the monetary authorities’ policy reaction function is crucial in determining the implications for interest rates of an endogenous monetary expansion. In more recent years, the focus of this debate has shifted in response to financial deregulation that has removed most required floors to reserve ratios, and which means that central banks no longer attempt to use quantitative constraints on bank reserves as an instrument of monetary policy. Instead, Dow (1996a: p. 499) argues that ‘it is capital adequacy ratios rather than reserve ratios which are now the operative constraint’ (citing Gardener, 1993; see also Arestis and Howells, 1996: p. 540). If a bank is already operating at its minimum capital adequacy ratio, then it cannot expand advances without a simultaneous increase in shareholders’ funds. If everything else stays the same, this is likely to require a higher rate of return on its assets, and so an increase in the money supply can be expected to be accompanied by a rise in the rate of interest on advances. Further, if capital adequacy ratios are the operative constraint, these cannot be relaxed by the central bank providing more reserves at the current base interest rate. On top of this consideration, there may also be real reasons – and not just monetary causes – why a higher interest rate is required as the banking system expands its balance sheet, particularly if the expansion involves loans for riskier investment projects. The ‘principle of increasing risk’ was first analysed in the context of bank loans by Kalecki (1937; see also Sawyer, 1985: pp. 103 and 197)

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and more recently by Barro (1976) and Tobin (1982). If the banking system tends to finance the safest available investment projects first, or if the risk of default increases as existing borrowers’ debt–equity ratios rise, then banks will generally be obliged to increase the rate of interest on bank advances as they extend more credit to compensate for the additional risks incurred. Coupled with the possible need to increase the return to shareholders in any case (in order to attract extra equity to satisfy capital adequacy ratios), this means that over the relevant range banks cannot expand credit without raising the rate of interest on bank advances. This will be a fundamental assumption adopted in later chapters of this book. Recall that the discussion just completed began by claiming there are two caveats to the conclusion that the stock of money automatically adjusts itself to economic conditions through the law of reflux. In contrast to the first caveat’s concern that there might be constraints on the banking system’s ability to supply extra money in response to demand, the second caveat questions the reverse mechanism – is it always true that excess money balances can be eliminated by repaying bank loans? In particular, suppose that the agents who borrow the bank advances are different from the agents who end up holding the bank deposits, and that a significant proportion of the latter group do not have any bank debt (Chick, 1986: p. 204, fn. 8; Cottrell, 1986: pp. 16–17; Howells, 1995b: p. 94). This is perfectly plausible, since bank loans are usually obtained, not to increase an agent’s money balances, but to finance planned expenditure. Almost by definition, therefore, the money created by the borrowing decision of one agent is typically immediately spent, and so passes to other agents. If some of these do not have bank loans (and so cannot automatically pay off bank debt if they do not want to hold the extra balances), this gives rise to what Howells (1997: p. 433) has termed ‘the reconciliation problem’. This is the key problem addressed in this book, and so deserves its own section. Eliminating an excess supply of endogenous money The example given in Table 3.4 above can be recognised as a very special case, since it involves a single agent who holds both bank deposits and bank loans. All can agree that in such a case there can never be an excess supply of credit-money, since a bank loan is not brought into existence unless the agent wants a higher balance for his or her bank deposits. More generally, however, bank loans are not sought for this reason but are sought to finance expenditure. In particular, firms operating in a monetary economy generally require working capital to finance production in advance of sales, because wages and the cost of other resources used in production must be paid before the revenue from selling the produced output is received. Thus the starting point of most endogenous money theory is to analyse the way in which this working capital is provided by bank loans, backed by the produced goods acting as collateral until they can be sold and the debt repaid. 5 In the case of consumption goods production, this analysis suggests no change in the basic result that an excess supply of endogenous money is impossible. This is because firms producing consumption goods can expect to retire their working

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capital loans directly from the proceeds of their sales, as shown in the stylised monetary circuit diagram of Figure 3.1. The circuit begins with the firms borrowing loans from the financial sector in order to finance the period’s production. The firms use this credit-money to pay their suppliers and workers (the first solid arrow in Figure 3.1), which then permits the recipients to purchase the consumption goods (the second solid arrow). The proceeds from the sales allow the firms to repay the original loans, and so the banking system is in a position to restart the circuit in the next production period (the dotted arrow). The monetary circuit in Figure 3.1 takes time to operate, of course, so that during the process economic agents hold deposits temporarily because they have not yet had time to spend them. These temporary money balances are matched by unsold inventory held by the firms and have been termed ‘convenience lending’ by Moore (1989b: pp. 480–3). 6 For investment goods production, however, there are added complications, since the produced capital goods are not sold directly to households in a circular flow of income and expenditure as is the case for consumption goods. Instead, agents who save out of their income are able to use their savings to purchase shares or equities issued by the firms (see Figure 5.3). To the extent that firms do not issue equities equal to the value of the new capital goods, therefore, some of the original finance loans cannot be repaid, producing a permanent increase in the endogenous money supply (an observation first made by Davidson, 1968; 1972: Chapters 11–13). This leads to the question of whether these extra money balances are willingly held by their recipients, reflecting the portfolio decision by households about the allocation of their new wealth between higher money balances and increased equity holdings. As Wray (1990: pp. 162–70) has emphasised, this means that the analysis of the flow demand for money (to finance the initial expenditure) must be complemented with an analysis of the stock demand for liquidity (that is the willingness of agents to hold the extra money

Figure 3.1 The monetary circuit for the production of consumption goods

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created). These complications justify the focus of the endogenous money literature on investment rather than consumption goods finance, which is also the focus of the analysis in this book. 7 To summarise, there are three decisions affecting whether or not an excess supply of credit-money may exist at some point in time: 1 the decision about what quantity of credit-money is created to finance investment; 2 the decision about the value of equities in the new capital stock sold to savers in the economy; and 3 the decision by wealth holders about what quantity of new credit-money they wish to hold. If these three decisions combine to produce an excess supply, what economic mechanism would be triggered to restore balance? 8 The traditional answer to this question – which is the point of departure for the analysis of this book – has been recently summarised in a series of papers by Howells (1995b; 1997) and Arestis and Howells (1996; 1999), who argue that changes in relative interest rates ensure that the quantity of credit-money supplied equals the quantity of credit-money demanded. A succinct summary is provided by Howells: We begin with the standard response to the excessive flow of new bank deposits. The result is a switch from money to bonds, a rise in price and fall in yields, and a portfolio readjustment of financial assets, followed by whatever changes in real expenditures may follow from this lowering of interest rates on nonmoney assets. To this point, the mechanism sounds orthodox Keynesian. Notice that the familiar narrowing of the spread between ‘bond’ and money yields, (RB – RM), leads to an increase in the demand for money and is a relevant first step toward reconciling demand with the ‘excessive’ increase in supply. The change in the ‘bond’ yield is also a change in the rate at which agents can borrow from nonbanks. Nonmoney interest rates fall relative to the rate on money, but also relative to the rate on bank lending. Nonmoney financial assets, however, are the liabilities of deficit spenders and as such are a partial substitute for bank lending as a means of finance (only partial since markets may be segmented by risk, transaction costs, even by regulation). With the cost of nonbank finance falling relative to the rate on bank lending, deficit units switch at the margin in favor of the former. (RL – RB), the bank lending– nonbank lending spread narrows, and this provides the second step, reducing the flow of new bank lending and deposits. (1995b: p. 102, emphasis in original) The ‘relative interest rates’ adjustment mechanism outlined in this quotation is straightforward. Agents use their unwanted credit-money balances to increase their demand for equities (adopting the language that will be used in this book to mean what Howells refers to as ‘bonds’, ‘nonmoney assets’ and ‘nonbank finance’),

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which increases equity prices. If future returns on equities are fixed, this increase in their price lowers their rate of return relative to the interest rate of both bank deposits and bank advances. Hence this leads to a substitution towards a higher quantity of bank deposits demanded and a substitution away from a lower quantity of bank advances accepted (reducing the value of bank deposits supplied), and so the excess supply is eliminated. As Arestis and Howells (1996: p. 549) rightly observe, this explanation ‘is consistent with the established literature on interest rates and monetary control... [enriched] by emphasising the role of the RL – RM spread’. Note, however, that the initial increase in equity prices produces a capital gain to existing shareholders. This may lead to real expenditure effects (as Howells acknowledges in the above quote), but it may also be a factor motivating the creation of excess bank deposits by the funding decisions of firms in the first place. That is, if the price increase was anticipated, the capital gains may have made the nominal interest rate on bank advances seem more attractive when the funding decisions were made. Also, the higher price of equities is likely to feed through into a higher price of capital goods (that is Tobin’s q-statistic has a longrun value of unity), which would then have implications for the debt-capital ratios of firms in their balance sheets that ought to be analysed. Further, the higher price of capital goods may in turn feed through into higher prices of consumption goods and higher wages, which would then require the analysis to question whether the rate of return on equities really will fall after the rise in their price. 9 In short, it may be that the important mechanism is not changes in relative interest rates (which may not happen under some circumstances) but the increase in equity prices itself. This is the hypothesis explored in this book. Endogenous money and inflation As was discussed in Chapter 1, the endogenous money axiom that ‘there can never be an excess supply of credit-money’ very often leads to a conclusion that endogenous money can never cause inflation. Instead, the normal argument is that the relationship is exactly the reverse, since firms will require larger bank loans to act as working capital if wages or other input prices rise, and so credit-money will be endogenously created in response to inflation (Weintraub and Davidson, 1973; Moore, 1979: pp. 66–67; Sawyer, 1983: p. 10; note also Le Bourva’s much earlier presentation of this theory, recently translated into English in 1992). Nevertheless, there has been a small but significant number of authors within the endogenous money school who have allowed credit-money to be at least a contributory cause to at least some types of inflation and in doing so have presented elements of the model that will be developed in the following chapters of this study. The earliest to do so was Hyman Minsky as part of his ‘financial instability hypothesis’ (see Minsky, 1976; 1982; 1986; discussions of this hypothesis in an endogenous money context have been provided by Dow and Earl, 1982: Chapters 11 and 12; Wray, 1990: pp. 135–138). In his famous interpretation of The General

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Theory, Minsky (1976) observed that Keynes had excluded capital goods (or equities) from his theory of liquidity preference. Minsky argued that this was a mistake, and he proposed that the demand for money should be adjusted ‘to explicitly introduce the price level of capital assets, PK, as a determinant of the demand for money so that changes in the quantity of money...can affect the price of capital assets’ (1976: p. 75; see also Dow, 1986: p. 100; Dow and Dow, 1989: p. 160; Wray, 1991b: p. 963). This allowed Minsky to develop his justly famous model of endogenous booms and collapses, in which a money-induced rise in PK leads to an increase in investment that in turn encourages greater credit expansion and financial innovation, causing further increases in PK, until eventually it is realised that the price of capital assets can no longer be supported by expected returns. This triggers a financial crisis followed by debt deflation, which may be exacerbated if the central bank does not accommodate the crisis-induced demand for extra liquidity. All of these elements will have a part to play in the model developed in the following chapters of this study. Elements of Minsky’s approach have been adopted by members of the ‘Structuralist School’, exemplified by Lance Taylor (1991; especially Chapter 4). In Taylor’s model, bank advances are determined by investment and government expenditure, private sector saving is a fixed proportion of income and the role of inflation is to reduce real money balances so that economic agents devote a proportion of their saving to increasing nominal money balances to compensate; all of which are features that will appear in the model of this book. The Structuralist School, however, incorporates the income distribution models of Kalecki (1935a) and Kaldor (1956) in a way that has been omitted from this present study, and the transmission mechanism from endogenous money to inflation is fundamentally different from the one described in Chapters 6–10 below. In particular, accumulated saving in Taylor’s model is held either as bank deposits (which are not included in the definition of the money supply) or as money (that is as ‘currency’ using this chapter’s terminology), so that there is no role for equities to play. Further, inflation in Taylor’s preferred model is not caused by money but is ‘structural inflation driven by class conflict and labor cost’ (Taylor, 1991: p. 101). Drawing on Marxist theories of money creation and inflation, Michel De Vroey (1984) assumes that money is created endogenously in response to the demand for investment finance, but then argues that this will have an inflationary impact if some of the investment projects turn out to be not well-founded. In such a case, entrepreneurs will suffer irretrievable losses that can be covered only by rolling over their initial short-term bank loans into a permanent granting of credit. This ‘extra money’ is not matched by production, and so inflation is generated. There is no link in this book’s model between the profitability or otherwise of investment expenditure and the repayment of bank loans (since the emphasis is on converting saving into equity rather than on using retained profits – that is company saving – to retire loans), but De Vroey’s recognition that the initial short-term loans may not be repaid will be a critical factor in the causal analysis of inflation in Chapter 7. Shirley Gedeon (1985–86) is another author to have recognised that endogenous money may cause inflation. Writing from the perspective of monetary institutions

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in the former Yugoslavia, Gedeon makes two points with much wider application. First, if central bank intervention restricts the ability of the banking system to extend credit, then it is possible for large firms to ‘create their own credit by issuing and transferring, for example, bills of exchange or by failing to meet debt obligations, thereby creating “involuntary” trade credit’ (1985–86: p. 209; see also Chick, 1984: pp. 177–9, and Winnett, 1992; for insightful essays on the social nature of money that can transcend central bank efforts to control its supply). This poses considerable problems for credit management, as Chapter 10 will discuss. Secondly, Gedeon recognises that firms with the ability to create ‘money’ in this way can use it to increase their share of real expenditure in the economy at the expense of other firms and households without this power. A similar mechanism will feature in this book’s model, although the benefit is an increased share in the equity in the economy’s capital stock, rather than in its real expenditure. Finally (and most influentially for this book), Victoria Chick (1984) records the results of her research stimulated by Ivor Pearce’s contention that ‘the Keynesians were misguided to think there could be investment in advance of saving that was not inflationary’ (Chick, 1984: p. 167). Chick begins by working through Keynes’s theory of investment finance to accept that an increase in investment must be financed by new money, and she then explores whether this new money must be inflationary, even if only eventually. After allowing for a one-off price increase accompanying the expansion in the capital goods industries, Chick argues that the new money need not be inflationary if it is used to purchase securities, but that it can be inflationary at any time that wealth holders ‘switch their attention to commodities, foreign currencies or land’ (p. 173); that is, whenever there is ‘a net shift out of financial assets’ (p. 174). In another essay published two years later, Chick returned to the question of whether bank credit could be inflationary and argued that new techniques of liability management developed during the 1970s mean that banks can find outlets for new loans ‘even in a slump’, and that their ‘aggressive lending activity may contribute to inflation’ (1986: p. 203). This important recognition that the banking system can create inflation as a side-effect of financing investment expenditure provides the foundation stone for this study’s attempt to explain how the underlying mechanisms operate. The starting point for the study is the income–expenditure multiplier framework developed using ‘process analysis’ by Richard Kahn and James Meade in the early 1930s. An explanation of that framework is the subject of Chapter 4.

4 Critical realism and process analysis

The modelling in subsequent chapters of this book is based on a combination of process analysis and equilibrium analysis. At least since Debreu (1959; 1962) introduced general equilibrium models into economics, the former technique has all but disappeared from the literature and so may be unfamiliar to many readers. The main purposes of this chapter, therefore, are to describe the method of process analysis and to illustrate its strength by explaining its essential role in discovering what was arguably the fundamentally new result in Keynes’s General Theory – namely, that an increase in investment expenditure gives rise to exactly the same increase in voluntary saving. 1 This important illustration from the history of economic thought also serves as a very good introduction to the modelling of this current book, which involves a very similar process analysis extended to include credit-money flows and the subsequent funding and liquidity preference decisions by firms and households. To provide a context for this chapter’s presentation, the first section discusses a philosophical approach in economics known as ‘critical realism’. This approach has been developed over many years in a research programme convened by Tony Lawson at Cambridge University (see the essays in Fleetwood, 1999) and lends itself particularly well to the methods adopted in this study. Critical realism 2 Recognition of the importance of process analysis – defined very broadly – is a feature of a philosophical perspective that Lawson (1994a, b; 1995a; 1997; 1999) has termed ‘critical realism’ (following Bhaskar, 1987; 1989), and Sheila Dow (1990b) has termed ‘process truth realism’ (following Mäki, 1988; 1989). This perspective was introduced into other social sciences in the early 1980s (see, for example, Sayer’s seminal text of 1984), but it has found a measure of support in economics only very recently, as the dates of the above references attest. For the purposes of this book, three elements of the critical realism paradigm must be highlighted: (1) its core hypothesis on the nature of social reality; (2) its consequent methodological guidelines for successful social science research; and (3) its implications for designing effective social policy. The starting point for the critical realist method is an ontological hypothesis that social reality is ‘structured’, in the sense that ‘there are enduring structures

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and generative mechanisms underlying and producing observable phenomena and events’ (Bhaskar, 1989: p. 2). Thus, whenever a researcher observes the existence of some particular ‘event regularity’ of the form ‘event z often occurs’ – where ‘event’ should be interpreted in the widest possible sense to include states of nature as well as specific historical episodes – the critical realist’s basic assumption is that there is some underlying mechanism, μ, which is producing the event regularity z. If, as is usually the case, the underlying mechanism is itself initiated by some other event, denoted x, a more precise representation of ‘event z often occurs’ becomes ‘event z has a tendency to occur whenever event x occurs’. Note the use of the word ‘tendency’. This is because it is possible for other mechanisms and processes to interrupt the process leading from x to z. Hence event z may not necessarily be observed every time x occurs, even though the claim is that event x always causes the mechanism μ to operate. An example from economics may be helpful. There have been periods in history during which real wages have clearly fallen, and these periods have generally coincided with high unemployment. Hence, it is a reasonable hypothesis to suggest that if there is high unemployment (event x), then real wages will fall (event z). This hypothesis could be examined empirically through the use of econometric techniques applied to suitable economic data on unemployment and real wages. Lawson (1994a: pp. 261–6) terms this approach ‘empirical realism’. For a critical realist, however, this method is inadequate since the critical realist also wants to understand the underlying mechanisms, μ, that are triggered by x and which cause z. In fact, there is a wide acceptance among economists concerning the mechanisms by which unemployment leads to lower real wages. First, in a period of high unemployment workers with jobs are more willing to accept a decline in real wages caused by rising consumer prices and less willing to take industrial action in support of claims for wage increases because of the high costs they must bear if they are dismissed or their firm is forced to close. Second, unemployed workers can improve their chances of employment by offering to work for employers (or on their own account) at lower than prevailing wage rates. It is also widely accepted, however, that this event regularity may not be observed every time there is high unemployment. For example, wage rates may already be at some minimum level set by statute and indexed to inflation (Brown et al., 1982). Social welfare payments may be providing alternative income support that reduces the incentive to accept lower-paid work (Minford, 1983). Perhaps trade unions are preventing unemployed outsiders from competing for their members’ jobs (Lindbeck and Snower, 1988). There are disagreements about whether each of these examples is a good or a bad thing from a social welfare point of view (compare, for example, the opposing stances taken by Forrest, 1984, and Wilkinson, 1992, on the issue of minimum wages), but there is also disagreement about how these later cases should be considered from a methodological perspective. For empirical realists, each of the counter-examples in the previous paragraph must be treated as part of the set of initial events, x, so that the hypothesis becomes ‘if there is high unemployment, and if there is no binding minimum wage, and if social welfare income support is not too generous, and if trade unions are ineffective

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in preventing it, then real wages will fall’. The empirical test is then likely to be a regression analysis that includes measures of all these items (unemployment, the minimum wage, the level of social welfare income support and the degree of trade union density) as independent variables explaining the dependent variable ‘changes in the value of real wages’. For the critical realist, however, the initial mechanisms, μ, are assumed to be operating whenever there is high unemployment, regardless of the presence or otherwise of minimum wages, welfare benefits or trade unions. Instead, each of the other events is associated with its own mechanisms that may interfere with, or counteract, μ, so that the final outcome for the real wage rate depends on the combined impact of all the mechanisms in operation. The distinction being made is a subtle one, but it is important for deriving sound principles for successful scientific research and effective policymaking. It is perhaps more easily understood using the illustration from the physical sciences that Alfred Marshall used to make the same point: Let us then consider more closely the nature of economic laws, and their limitations. Every cause has a tendency to produce some definite result if nothing occurs to hinder it. Thus gravitation tends to make things fall to the ground: but when a balloon is full of gas lighter than air, the pressure of the air will make it rise in spite of the tendency of gravitation to make it fall. The law of gravitation states how any two things attract one another, and will move towards one another if nothing interferes to prevent them. The law of gravitation is therefore a statement of tendencies. (1920: p. 31) Note Marshall’s use of the word ‘tendency’, which he justifies in terms very similar to the critical realist account given above (a point noted by Lawson, 1989a: p. 62). The important question at issue is whether the example of a hot-air balloon should be treated as an exception to ‘the law of gravitation’ or as an instance where the underlying mechanism of gravity is outweighed by another, more locally powerful, mechanism. Of course, the latter is the dominant view among scientists (and indeed the practice of carefully controlled laboratory experiments only makes sense if it is assumed that the mechanisms discovered in artificial laboratory conditions will continue to apply in the natural world; see Bhaskar, 1989: p. 16), and similarly it can be said that competitive forces are always present in a country’s labour markets, even when the presence of other mechanisms means that certain tendencies expected from the operation of competitive forces are not observed. From this view of reality as ‘deeply structured’, it follows that the objective of critical realist science is ‘to identify and understand [the] real structures or mechanisms that govern the (equally real) phenomena that are experienced’ (Lawson, 1989a: p. 62; see also 1989b: p. 239). This might be contrasted with Milton Friedman’s (1953) ‘instrumentalist’ position in his famous essay on methodology. In Friedman’s view, the principal criterion for successful economic theorising is the power of the theory to make accurate predictions using the most simple available assumptions (which will typically be ‘unreal’). For a critical

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realist, on the other hand, a successful theory must also be able to explain the underlying mechanisms that cause the identified regularities (and so its assumptions must be fundamentally ‘real’). Such explanatory theories are relatively easy to test in the physical sciences, where controlled laboratory experiments can be designed to isolate any phenomenon under study from other countervailing (or reinforcing) tendencies. In the social sciences, however, the task is made considerably more difficult by the impossibility of creating such laboratory conditions, and hence the need for researchers to rely more heavily on thought experiments and on sophisticated econometric techniques to isolate any hypothesised social tendency. Again an early statement of this view can be found in Marshall (1920), where he made the following observation during his explanation of the method of ‘partial analysis’: In breaking up [complex questions], [the researcher] segregates those disturbing causes, whose wanderings happen to be inconvenient, for the time in a pound called Ceteris Paribus. The study of some group of tendencies is isolated by the assumption other things being equal: The existence of other tendencies is not denied, but their disturbing effect is neglected for a time. The more the issue is thus narrowed, the more exactly can it be handled: but also the less closely does it correspond to real life. (1920: p. 366) Note carefully Marshall’s statement that ‘the existence of other tendencies is not denied’, even as they are put into the Ceteris Paribus pound, but the method does not allow them to have any influence for the time being on the issue under investigation. As noted above, for this strategy to be sensible it must be expected that the tendency thus analysed will continue to hold once the other tendencies are released from the Ceteris Paribus pound. This will be so if the researcher believes he or she is analysing underlying structure rather than simply event regularities. The practical importance of these consideration lies in the third aspect of critical realism highlighted here; namely, the statement that the successful explanation of underlying structure is an essential prerequisite for effective policymaking. This is because if policymakers do not understand the underlying processes, but instead attempt to exploit some presumed event regularity at the level of event regularities only, their actions will be subject to what in the economics literature is called Goodhart’s Law (Goodhart, 1975: p. 96, referring particularly to monetary policy) or the Lucas critique (Lucas, 1976, referring particularly to econometric model building); namely, that any change in public policy will produce changes in people’s behaviour that will typically render the original event regularity invalid (see Lawson, 1995b, for a lengthier discussion). There are other dangers to consider; for example, outcomes may turn out to be dependent in some way on the processes themselves (termed hysteresis; see Cross, 1988), so that a policy initiative which does not consider the process of adjustment from one equilibrium to another may be unduly optimistic or

Critical realism and process analysis

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pessimistic in its assessment of the costs and benefits of the initiative. Further, in a non-ergodic world it may be impossible to manipulate ‘events’ to produce constantly improving outcomes, although it may be possible to modify underlying mechanisms to move towards desired policy objectives. Hence, the critical realist approach counsels policymakers ‘to understand the processes underlying structural change (and structural stability)’ (Dow, 1990b: p. 352), since ‘any successful program of change must be rooted in an understanding of how economic processes function within existing institutions’ (Minsky, 1986: p. 3). Once the processes are understood, policies can be designed to prevent some undesirable mechanism from having its effect by introducing another mechanism as a counter-process (for example introducing a statutory minimum wage rate to prevent competitive forces from pushing wages below a certain level during high unemployment). Alternatively, policies can be designed to ensure that a desired mechanism is allowed to operate by legislating against other mechanisms that might otherwise interfere (for example, anti-trust legislation to inhibit large companies from disrupting competitive market forces). In summary, then, critical realism holds that event regularities in social reality are produced by enduring structures, that the object of social science should be to explain these structures and that policymakers should use the explanations produced by social scientists to transform undesirable mechanisms into better ones. Within this framework, process analysis is an important technique for the purposes of explanation and policy design. Process analysis and equilibrium analysis Consistent with the just discussed norms of critical realism, the research reported in this book begins with a process analysis of the underlying expenditure and money flows that give rise to the basic mechanism of price inflation being examined. The research then uses this structure to build an equilibrium model of the money market to give some strong mathematical results about real economic growth, the rate of interest and asset price inflation. This second step may surprise some readers, since there is a strong presumption within post-Keynesian economics that equilibrium analysis is not acceptable. Indeed, Joan Robinson argued that rejection of equilibrium analysis was one of the revolutionary achievements in Keynes’s General Theory: 3 Consider what was the point of the Keynesian revolution on the plane of theory and on the plane of policy. On the plane of theory, the main point of the General Theory was to break out of the cocoon of equilibrium and consider the nature of life lived in time – the difference between yesterday and tomorrow. (Robinson, 1972: p. 3) On the other hand, some economists taking the opposite position – that process analysis (or sequence analysis as it is sometimes termed) should be abandoned in

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favour of equilibrium analysis – have also claimed Keynes as their champion. Consider, for example, the following interpretation by Meir Kohn (1986; see also Schumpeter, 1947: pp. 92–3): While the General Theory did make significant new contributions of substance to this neoclassical tradition, it represented a truly startling revolution in method. This revolution lay in Keynes’s abandonment of sequence analysis in favor of the method of equilibrium. (Kohn, 1968: p. 1191) It is a testimony to Keynes’s genius – or perhaps to his lack of clarity in expressing new ideas – that such eminent scholars can reach conclusions which are so radically different, particularly since both Robinson and Kohn understand their respective interpretations to reveal a revolutionary departure by Keynes from the previously accepted method. The approach adopted in this study, however, is to argue that this distinction is a false dichotomy. 4 Instead, consider the following statement by James Meade in which he comments on the way in which he and his Cambridge colleagues in the 1930s treated the famous Kahn multiplier process by which an increase in investment expenditure leads to an even larger increase in gross domestic product: We were not interested in temporary distortions of short-run equilibria, but only in the nature of those equilibria. We accordingly assumed (unrealistically?) that the operation of the multiplier and so of Mr Meade’s Relation was very rapid. This relation clearly implied that adjustments in total demand for goods and so in total income constituted the method by which equilibria in the macro-economy were attained. (Meade, 1993: p. 665) There are two components in this method as reported by Meade. First, the researchers uncovered ‘the operation of the multiplier’, which the following section will show was done using process analysis. Next an assumption was made that this process operated very rapidly, so that equilibrium analysis could then be used to give some definite results. I will shortly argue that both components were essential, but it is fair to say that the modern tendency of economics to focus on numerical equilibrium analysis has allowed the foundational process analysis to slip from view. This may also have been facilitated by what Fouraker has called ‘the Cambridge didactic style’ (Robinson, 1953: p. 263, makes a similar comment on Keynes’s writing): When faced with a subtle, yet complex, problem in the development of a concept, both [Keynes and Marshall] would assault it with all the resources at their command: logic, mathematics, statistics, intuition. ... Having satisfied themselves, however, they employed a curious device when it came to recording the results of their pursuits. Instead of leading the reader through the intricate

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analytical processes that their own minds had recently transversed, they would provide a short cut, in the form of an assumption whose purpose was to eliminate consideration of the difficult problem they had faced and solved. (Fouraker 1958: p. 66) Thus, it is not contradictory to claim that process analysis was important in discovering the multiplier mechanism while observing that much of The General Theory takes the form of equilibrium analysis (but not all; consider, for example, the material in its Chapter 12). The approach taken in this present study is to argue that each method has its place within an economic research programme. After a process analysis has been used to trace out the underlying social and economic mechanisms that are producing the event regularities under investigation, equilibrium analysis can then be used to explore questions such as how the outcome might be different if critical parameters have different initial values (‘comparative statics equilibrium analysis’), and how the outcome might evolve over time if the underlying processes are permitted to operate without interference (‘dynamic equilibrium analysis’). Thus, Chapters 5 and 6 will use process analysis to explain how investment expenditure produces an identical level of voluntary saving, and to analyse the financial flows associated with this process. Chapter 7 and the remainder of the book will then use equilibrium analysis to model how this process can produce inflationary pressures in a modern market economy, and how the monetary authorities can maintain price stability more efficiently than currently is the case when such pressures emerge. Mr Meade’s Relation The previous section has already suggested that the discovery and development of the investment multiplier provides a good example of how process and equilibrium analysis can operate together in a research project. This last section will expand on that suggestion, drawing on a fascinating two-page note published by James Meade (1993) shortly before his death. The note was a response to requests for Meade to record his memories of the ‘Cambridge Circus’, in which he described how he discovered what Richard Kahn (1931: p. 188) called at the time ‘Mr Meade’s Relation’. 5 Meade explained in his note that he went to Cambridge for the academic year of 1930/1, where he soon became friends with Kahn. Thus he became aware of Kahn’s multiplier analysis showing how an increase in investment expenditure, ΔI, leads to a larger impact on aggregate income, ΔY, according to the formula: ΔY = ΔI(1 – c)

(4.1)

where c is the propensity to consume out of income, and it is assumed for simplicity that there is no government and no external trade. Meade ‘decided as an exercise in the Higher Mathematics to repeat the [multiplier] exercise summing not what income recipients decided to spend but what they decided to save, replacing the

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propensity to consume (c) by a propensity to save (s)’ (1993: p. 665). The result was a diagram, reproduced here in a slightly modified form (mainly involving a transpose rotation to make it compatible with later diagrams in this present study) as Table 4.1. The diagram is an example of ‘process analysis’, in which some exogenous event is assumed (in this case an increase in investment expenditure, ΔI) and the subsequent economic flows are analysed in logical time (represented by each round of the process). 6 Thus, the first row of the diagram shows that the increased investment expenditure is received by the agents involved in the new investment projects as increased income, ΔY0. In the next round of the process, a constant proportion, s, of this increased income is saved, ΔS1 = sΔI, whereas the remainder is spent on consumption, ΔC1, providing new income for owners of the factors of production in the consumption goods industries, ΔY1. The extra income generated by this increased consumption allows further voluntary saving, ΔS2 = s(1 – s)ΔI, and consumption, ΔC2 = (1 – s)2ΔI, which pushes the process into round 2. The income–expenditure process continues until extra consumption falls asymptotically to zero. By assuming a constant propensity to save, Meade was

Table 4.1 Process analysis of Mr Meade’s Relation

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able to apply the formula for the summation of a geometric series to confirm Kahn’s result that income would increase by the multiple given in Equation 4.1 above and to prove his own relation that at the end of the process the increase in voluntary saving would exactly equal the initial increase in investment expenditure. ΔS = ΔI

(4.2)

The economic intuition behind Equations 4.1 and 4.2 is straightforward. If income earners find that they have more savings than they wish, the solution is to spend more on consumption. This, however, simply transfers the savings in the form of new income to those providing the consumption goods, and so there is no change in the level of aggregate saving. Chapter 5 will use a more general process analysis to show that this result does not rely on Meade’s special assumption that the propensity to save in each round of the process is constant, but is the result of what I have previously called a ‘saving conservation principle’ (Dalziel, 1996b), and continues to hold when the model is extended to include the unique role played by credit-money in financing investment expenditure in advance of the subsequently induced voluntary saving. In his tribute to Richard Kahn, Austin Robinson (1994: p. 8) observed that the multiplier analysis is so simple and so taken for granted now that ‘a younger generation can scarcely understand how I or someone had not seen the answer for myself as soon as the question was asked’. As Keynes put it in his preface to The General Theory, ‘the difficulty [lay], not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds’ (1936: p. viii). In this case, the old idea to be escaped was the classical doctrine that planned investment (‘demand for loanable funds’) would equal voluntary saving (‘supply of loanable funds’) only in equilibrium at the ‘natural’ rate of interest. 7 Proving that investment expenditure necessarily created an equal amount of voluntary saving – regardless of the rate of interest – demolished that theory, which is the reason that many Keynesian scholars have argued this was the key theoretical development in The General Theory (see fn. 1 of this chapter). Given the acceptance of equilibrium techniques in this book, the reader is entitled to ask whether an initial process analysis is necessary. Emphatically, the critical realist answer is yes. Consider the following example of what may happen if the process analysis is overlooked. Chapter 5 will confirm (in the process analysis of Figure 5.1) that Mr Meade’s Relation applies to all investment expenditure, and not just to an increase in investment, so that the following equality holds: S=I

(4.3)

where S is the level of voluntary saving and I is the level of investment. In textbooks, this relation is generally derived as an equilibrium condition in which planned supply equals planned demand (giving rise, for example, to the IS schedule in

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Hicks’s famous IS–LM model), and so its process analysis origins are overlooked. As an equilibrium condition, of course, there is no causality implied in Equation 4.3, so that the Keynesian conclusion that investment expenditure causes voluntary saving is hidden. Further, it is tempting to transform the equilibrium condition as follows. By definition, investment is the change in the capital stock, ΔK, whereas the capital-output ratio can be denoted by ␬ = K/Y, and the average rate of voluntary saving out of income by σ = S/Y. Thus the rate of growth in the economy’s supplyside capacity, g, is easily shown to be given by: g =ΔK/K = (I/Y)/(K/Y) = (S/Y)/(K/Y) = σ/␬

(4.4)

This is a very clear result, and such clarity is of course the great strength of equilibrium analysis. Equation 4.4 appears to suggest that an economy’s growth rate depends on two simple factors: the saving rate divided by the capital-output ratio. Assuming the latter is fixed, this leads to the apparent implication that policymakers can increase growth by encouraging households to save a higher proportion of their income. Indeed, this policy advice is widely offered by economists. Yet, consideration of the process analysis underlying Equation 4.3 reveals that these appearances are false. As Keynes (1936: p. 84) himself put it in The General Theory: ‘Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.’ This is because the process analysis reveals that it is the level of capital accumulation which determines the level of saving, not the other way around (as will be discussed further in Chapter 5). This example illustrates the critical realist argument that successful explanation of underlying structure is an essential prerequisite for effective policymaking. This in turn requires that the equilibrium analysis stage of a research project does not ignore the underlying mechanisms revealed by the process analysis of the first stage. In short, sound economic theory is built upon a constant interplay between process analysis and equilibrium analysis. This was the approach adopted by Keynes in The General Theory, and the study of this book follows his example.

5 Keynes’s revolving fund of investment finance

Although Meade’s analysis of the identity between investment and saving was an important contribution to the development of The General Theory, it suffered from two significant weaknesses. First, the propensity to save was held to be constant for all rounds of the process. This was not simply a heuristic assumption by Meade, but was essential if he was to use the formula for the sum of a geometric series in order to obtain his result. This raises a question whether perhaps the relationship holds only in this special case. Second, Meade’s analysis did not address the matter of the financial flows associated with the investment expenditure and saving. This left a critical gap in the theory, for if investment is not financed by savers making available their ‘free capital’ for transformation into ‘fixed capital’ – as Marshall (1920: pp. 62–3) had put it – but instead the voluntary saving takes place after the expenditure on fixed capital formation, how then is that expenditure initially financed? Keynes addressed the first of these weaknesses in Chapter 7 of The General Theory and the second in two articles published in the Economic Journal the following year. The chapter in The General Theory explained how investment expenditure must lead to an equal amount of voluntary saving under any circumstances, whereas the two 1937 articles analysed the role of credit granted by the banking system in financing investment expenditure. The latter analysis is known as Keynes’s theory of the revolving fund of investment finance. It is particularly interesting for endogenous money theorists, because the model integrates money into the real economy in a way that is more realistic and insightful than can be found in exogenous models such as Hicks’s (1937) IS–LM translation of The General Theory. In this present study, Keynes’s theory of the revolving fund is an important step towards the finance theory of inflation that will be presented in Chapter 7. The generality of Mr Meade’s Relation In this section Meade’s (1993) model presented in the previous chapter is extended in two ways. First, the unit of analysis is taken to be the level of investment expenditure, rather than its increase over the previous period’s value. Second, the analysis removes the restriction that saving is always a constant proportion of

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income. Removing this restriction means that the formula for the sum of a geometric series can no longer be used, but it will be shortly shown that this does not matter since the logic of Meade’s process analysis is sufficient to prove that investment equals voluntary saving, regardless of how the saving decisions are made in each round of the multiplier process. 1 Consider Figure 5.1. The level of investment expenditure during the initial period of analysis, I, immediately generates income, Y0, for the factors of production involved in producing the capital goods. Some of this income is held as voluntary saving, S1, whereas the rest is spent on consumption goods, C1. This latter action creates income for agents involved in the production of consumption goods, represented by Y1 at the end of the first round of the analysis. Even at this point of the analysis, note that the level of saving (that is S1 + Y1, being the total income not consumed) equals the level of investment, but only the first term, S1, is ‘voluntary saving’. The second term is being held only because the income recipients have not yet had time to make their consumption and final saving decisions. In the next round of the process, the income Y1 comes to be divided between voluntary saving, S2, and consumption expenditure that generates further income, C2 = Y2. Again, accumulated saving equals investment (that is S1 + S2 + Y2 = I), and again the last item on the left-hand side of the equation is not yet voluntary saving. The process continues in this way until eventually (or perhaps asymptotically) a round occurs in which all of the additional income is voluntarily held as saving. Because in every round the initial investment is matched by accumulated voluntary saving plus additional income, and because the final round is defined by the absence of additional income (since there is no consumption), it follows that the multiplier

Figure 5.1 A generalised demonstration of Mr Meade’s Relation

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process concludes with exactly sufficient voluntary saving to justify the increased investment. This diagrammatic analysis can be confirmed in a simple algebraic model taken from Dalziel and Harcourt (1997). Consider the following equations, which are true for all rounds of the income–expenditure process, where r ⱖ 1. I ≡Y0

(5.1)

Cr≡Yr

(5.2)

Sr≡Yr – 1 – Cr

(5.3)

Note that all three equations are identities; that is, they are true by definition. Equations 5.1 and 5.2 record that an act of expenditure for one agent (on investment or consumption goods respectively) must generate an equal amount of income, and Equation 5.3 records that all income in this two-sector model not spent on consumption is voluntarily saved. The three equations then imply that at the end of any round for r ⱖ 1: (5.4) Equation 5.4 repeats the observation just made that in every round of the process the investment expenditure is matched by accumulated voluntary saving plus the round’s yet to be allocated income, until eventually (perhaps asymptotically) a round occurs in which all of the additional income is voluntarily held as saving. In this terminal round denoted T, YT = 0, and Equation 5.5 records from Equation 5.4 that the process concludes with exactly sufficient voluntary saving to match the initial investment; that is: (5.5) The logic behind this result is that throughout the process a ‘saving conservation principle’ operates, in the sense that once the initial investment takes place, the total excess of income over what is spent on consumption continuously – that is throughout the process, and not just at its conclusion – equals the value of investment expenditure. Any attempt by someone to reduce saving by spending more simply transfers his or her share of the aggregate income-not-spent to another agent, whereas an attempt to increase saving by consuming less denies income to those agents who otherwise would have sold extra consumption goods or services. This logic was explained by Keynes in Chapter 7 of The General Theory as follows: The reconciliation of the identity between saving and investment with the apparent ‘free-will’ of the individual to save what he chooses irrespective of what he or others may be investing, essentially depends on saving being, like

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spending, a two-sided affair. For although the amount of his own saving is unlikely to have any significant influence on his own income, the reactions of the amount of his consumption on the incomes of others makes it impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself. It is, of course, just as impossible for the community as a whole to save less than the amount of current investment, since the attempt to do so will necessarily raise incomes to a level at which the sums which individuals choose to save add up to a figure exactly equal to the amount of investment. Keynes (1936: p. 84) Mr Keynes and the classics Since the publication of The General Theory in 1936, there have been many attempts to distil the major points of difference between Keynes and the economic theorists who preceded him. The title of this section, for example, comes from the first – and still most influential – paper by Hicks (1937), in which he introduced his famous IS–LM model. In that paper, Hicks argued that the main difference was that Keynes’s theory analysed the ‘economics of depression’ in contrast to the classical school’s analysis of full employment. There is no doubt that Keynes’s theory of effective demand did allow him to analyse outcomes in which there is high persistent unemployment, but this study adopts the view that the distinguishing characteristic of The General Theory was not this result per se, but was the recognition behind the result that the level of voluntary saving is determined by investment in new capital goods through changes in national income rather than the rate of interest. As Bridel (1987: p. 159) observes immediately after quoting the passage just cited above, this central analytical argument ‘cuts through several Gordian knots of the pre-1936 trade-cycle theory’. 2 In the classical theory of saving and investment, capital accumulation was made possible by the prior decisions of individuals to save some of their income as ‘floating’ or ‘free’ capital (Marshall, 1920: p. 341). Their decision to save was held to be positively influenced by the rate of interest (which Marshall called the reward for waiting), so that the supply of free capital (or of ‘loanable funds’) could be represented by an upward-sloping curve, labelled S in Figure 5.2. The matching demand curve, labelled I, came from individuals who required this ‘command over capital’ to invest in ‘real capital’ of one type or another. It was taken to be downward sloping for the universally accepted reason that investment projects are undertaken only if they can be expected to generate a sufficiently high rate of return to meet the interest rate on borrowed funds (whether debt or equity). The point of intersection between the two curves in Figure 5.2 determined the equilibrium level of saving and investment at what Wicksell (1907) called the ‘natural rate of interest’, denoted here as in. The intermediation between savers and borrowers might generally take place through specialist agents, particularly through banks or the stock exchange, but

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Figure 5.2 The classical theory of saving and investment

the direction of causation in the classical model was emphatically from savings to investment. 3 This theory was explicitly challenged by Keynes in The General Theory. Indeed, the only diagram in that book is a depiction of investment and saving similar to that shown in Figure 5.2 (although with transposed axes), followed by an explanation that the diagram does not contain enough data for its intended purpose (Keynes, 1936: pp. 180–1). This is because the position of the savings curve depends on the prevailing level of income, but the multiplier analysis reveals that the level of income is affected by changes in the quantity of investment. Thus a movement along the investment curve, for example, must cause the savings curve to shift since it implies that aggregate income is changing. The theoretical and policy ramifications of this insight are profound. At the theoretical level, it means that an alternative model for the rate of interest must be constructed, since if voluntary saving is determined by the level of investment, the classical model cannot explain what causes interest rates to change. 4 At the policy level, it means that exhortations or policy incentives for households to increase their savings cannot be relied upon to increase the rate of capital accumulation in order to increase economic growth. Such exhortations and incentives may affect the distribution of saving throughout the economy but will not change the level of saving predetermined by the level of investment expenditure. These results are not widely accepted among economists, and so it is important to emphasise just how robust is the underlying multiplier analysis in Equations 5.1– 5.5 and in Figure 5.1. The analysis rests on two simple identities: expenditure equals income and income is either consumed or saved. Given these identities, it must be true as a matter of algebra that any level of investment expenditure gives rise to the same level of voluntary saving, as derived in Equation 5.5. There is no

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Keynes’s revolving fund of investment finance

role for the rate of interest to play in this process. At any moment in time, aggregate saving must equal (net) aggregate investment with the only distinction being between those savings that can be described as voluntary and those that are temporary as their owners take time to make their consumption decisions. As James Meade (1975: p. 82; emphasis in original) described in his memorable metaphor, ‘Keynes’s intellectual revolution was to shift economists from thinking normally in terms of a model of reality in which a dog called savings wagged his tail labelled investment to thinking in terms of a model in which a dog called investment wagged his tail labelled savings.’ The revolving fund of investment finance The first two sections of this chapter have explained the fundamental Keynesian result that investment always generates an equal amount of voluntary saving subsequently. This leaves an important problem – how is the expenditure initially financed, given that the saving does not occur until after the event? Keynes did not discuss this in The General Theory, but presented an analysis of what is termed the revolving fund of investment finance in two papers published the following year (Keynes, 1937c, d). 5 The second article is perhaps the clearer of the two and was written as part of an exchange with Bertil Ohlin in which Keynes defended his view that the interest rate is not influenced by the need for investment finance. This is because the banking system can supply firms with finance on demand with no impact on liquidity preference, and subsequent saving can then be used to retire the original loans when new equities are sold to the savers. In a steady state with a constant level of investment every period, the amount of finance created for current investment plans would just equal the amount of finance being retired out of current saving generated by the previous period’s investment. These components of Keynes’s revolving fund theory are summarised succinctly in the following passage: I return to the point that finance is a revolving fund. In the main, the flow of new finance required by current ex ante investment is provided by the finance released by current ex post investment. When the flow of investment is at a steady rate, so that the flow of ex ante investment is equal to the flow of ex post investment, the whole of it can be provided in this way without any change in the liquidity position. (Keynes, 1937d: pp. 219–20) A stylised version of the revolving fund is presented in Figure 5.3, which shows a monetary circuit for production of investment goods (which can be contrasted with the monetary circuit for production of consumption goods in Figure 3.1). 6 The circuit begins with firms borrowing from the financial sector in order to finance production of capital goods. This credit-money is used to pay their suppliers and workers (the first solid arrow in Figure 5.3). The multiplier process proceeds (to be analysed in greater detail shortly) until voluntary saving equals the value of the

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Figure 5.3 The monetary circuit for the production of investment goods

investment expenditure. The savings are used to purchase equities in the new capital stock, and the proceeds from the equity sales allow the firms to repay the original loans. This replenishes the revolving fund, and so the banking system is in a position to restart the circuit in the next production period (the dotted arrow). This revolving fund theory in Figure 5.3, together with the investment-saving multiplier relation presented in Figure 5.1, provide the core model of this book. They are brought together in the process analysis of Figure 5.4, which is similar to Figure 5.1 with one important difference: Figure 5.4 recognises the finance flows associated with the investment and saving flows. The demarcation between the finance and real flows is marked by the equality signs on the left-hand side of the first row of the diagram and on the right-hand side in each of the subsequent rounds of the process analysis. In the initial transaction, firms undertaking investment expenditure require money finance, denoted F, to pay income to the factors involved in producing the capital goods. In keeping with Keynes’s terminology, this money comes from a revolving fund of investment finance. 7 In the first round of the subsequent multiplier process, some of the income, Y0, is spent on consumption, C1. This generates new income as in Figure 5.1, and also transfers an equal value of money to the new income earners. The remainder is saved, S1. This represents income not spent, but in this extended analysis it is also money not spent. Let all of this residual money be used to purchase shares of equity in the new capital stock (this key assumption will be examined more carefully in Chapter 6), with the new equity denoted by ΔE1. This transaction returns money to the investing firms (in exchange for the equity shares), who use that money to repay an equal proportion of their financing arrangements, denoted R1. These repayments replenish the revolving fund. The process of expenditure, saving, equity purchase and finance repayment continues until a round occurs in which all new income (from the previous round’s consumption expenditure) is voluntarily saved (perhaps asymptotically). At this

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Keynes’s revolving fund of investment finance

Figure 5.4 Process analysis of Keynes’s revolving fund of investment finance

point the original investment expenditure is exactly matched by voluntary saving (from Equation 5.5 above), so that the value of new equity in the economy’s capital stock exactly equals both the original investment expenditure and the saving; that is: (5.6) Further, since F = I and ΔEi = Ri in each round, the sum of finance repaid just equals the value of the initial finance borrowed: (5.7) This result is the foundation of Keynes’s revolving fund of investment finance. As discussed in Chapter 4; however, the process analysis in Figure 5.4 takes place in logical rather than in historical time. Keynes’s approach to this problem was to assume an instantaneous multiplier, in the sense that for a particular level of

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investment in the previous interval of time, denoted It–1, the associated multiplier process is assumed to be completed within the current interval of time, t, so that St equals It–1. Let us also assume that the purchase of equities takes place in the same period as the saving, so that St equals ΔEt. Under these assumptions, Equation 5.7 becomes: Ft–1 = It–1 = St = ΔEt = Rt

(5.8)

Equation 5.8 has a number of attractive features. It emphasises, for example, that saving is caused by investment, since the current period’s savings is determined by the previous period’s investment. It also highlights the difference between shortterm ‘finance’, Ft–1, and long-term ‘funding’, ΔEt, in allowing investment, It–1, to proceed. 8 Finally it demonstrates the connection between saving and the new capital stock, since savers hold their new wealth in the form of new equities. Despite these attractive features and its authoritative pedigree, the instantaneous multiplier assumption may need some further justification since it is obviously ‘not real’ in the critical realist sense discussed in Chapter 4. This criticism is known as the Asimakopulos critique, after Tom Asimakopulos (1983) claimed that a multiplier process which takes time means that saving rates influence investment rates, contrary to Mr Meade’s Relation. 9 As Robertson (1936) and Kaldor (1939: p. 21) first explained, however, allowing the multiplier process to take time increases the size of the revolving fund needed to finance any given level of investment expenditure per period, but the basic mechanism is otherwise unchanged (see Wells, 1981, for a recent and slightly more general explanation). The larger revolving fund is required because it must not only finance a particular interval’s investment, but also the money balances being temporarily held by agents who have not yet had time to complete their consumption and saving decisions arising out of previous investment projects. Following Kaldor’s (1939) analysis, for example, suppose that each round of the multiplier process takes exactly one unit of time (called an interval), and suppose that the marginal propensity to save is constant throughout. How large an injection of new investment funds is needed to support a permanent increase in investment expenditure of ΔI under these circumstances? Kaldor’s analysis is given in Table 5.1. In each time interval, there is extra investment requiring new funds given by ΔI, and these amounts are recorded in the second column of the table. The revolving fund is replenished as agents save a constant proportion, s, of each interval’s new income. In the first interval, this is zero. In the second interval it is s multiplied by the first period’s ΔI. In the third interval, it is s multiplied by the second period’s ΔI plus s multiplied by the consumption expenditure arising from the first period’s ΔI; that is, ΔI + s(1 – s)ΔI. The replenishment in each interval is recorded in the third column of the table, and the final column records the difference between new and returning funds. Summing the items in the final column using the formula for the sum of an infinite geometric series gives the result that the revolving fund must increase, not by ΔI as in the instantaneous case, but by ΔI/s.

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Table 5.1 Kaldor’s revolving fund with a non-instantaneous multiplier

This last observation may seem to support Asimakopulos’s argument that saving behaviour (the value of s) can affect investment. If, for example, a larger sized revolving fund put pressure on interest rates to rise, then a lower value for s would discourage investment through this mechanism. Note, however, that even in this case the real constraint is the assumed liquidity constraint limiting the banking system’s ability to provide extra finance at a constant interest rate and not a savings constraint per se. Note also that if agents did increase their marginal propensity to save in order to reduce the size of the funds required (and so allow a greater increase in investment for a fixed ΔF), this would not lead to a higher level of national income, since the higher propensity to save would reduce consumption expenditure by the same amount as investment was increased. To demonstrate this, let the total increase in funds available be given by ΔF. Then, from the last row of Table 5.1, the amount of new investment that can be financed is given by: ΔI = sΔF

(5.9)

In this simple model, the increase in national income (ΔY) is given by the standard Keynesian multiplier: ΔY = ΔI/s

(5.10)

From Equations 5.9 and 5.10, ΔY = ΔF, and it is clear that the constraint on economic growth is the finance constraint, not any savings constraint. Kaldor’s assumption is, of course, as special (or ‘unreal’) as Keynes’s instantaneous assumption. Nevertheless, the above discussion illustrates the more general principle that however saving behaves – whether it is a fixed fraction of new income, or whether it occurs instantaneously or over a longer timeframe – the only impact it has on the analysis is the size of the revolving fund of investment finance that must be provided by the banking system to accommodate any particular level of investment expenditure. The advantage of Keynes’s assumption is that it allows a few simple mathematical derivations (see Chapter 7) to draw out some important implications of the underlying economic processes that might otherwise remain hidden. It is not claimed that these mathematical results will be reflected

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exactly in reality (because the instantaneous multiplier assumption is not real), but it is claimed that the results accurately reflect economic tendencies which need to be understood to design more effective public policy (particularly monetary policy in this case; see Chapter 10). Figure 5.5 depicts how the finance, investment, saving and repayment flows take place through time under the instantaneous multiplier assumption. In particular, it shows how in each period saving from the previous period’s investment projects (converted into equity) releases funds that are available to finance the current period’s investment projects. Thus, if there is no growth in the level of capital formation over time, investment finance is a self-replenishing revolving fund as Keynes (1937d: p. 220) suggested: ‘the flow of new finance required by current ex ante investment is provided by the finance released by current ex post investment.’ This may give the appearance that in each period saving is releasing funds for investment (as the classical theory suggests), but the strength of the process analysis in Figures 5.1 and 5.4 is to demonstrate that the saving is always created by the investment, although the latter requires finance that can be drawn from the savings arising from the previous period’s investment. The importance of this characterisation of investment, saving and finance as an alternative to the classical model can scarcely be exaggerated, and indeed Keynes (1937d: p. 222) himself described the proposition that that the investment market can become congested through a shortage of cash finance, but never by a shortage of saving as ‘the most fundamental of [his] conclusions within this field’. The analysis of this section also allows an insight into some characteristics of money that will be important in subsequent chapters. First, note that the money enters into the economic system by way of financing expenditure on capital formation. This is perfectly reasonable if the finance is credit-money created in the form of bank loans to the investing firms, since it means that the new capital is able to act as collateral for the loans until they are repaid. It also means that the money

Figure 5.5 Keynes’s revolving fund with an instantaneous multiplier

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Keynes’s revolving fund of investment finance

on issue is effectively backed by the value of the real capital assets it has financed, and it is this feature of the model that will allow a finance theory of inflation in Chapter 7. Finally, note that once the investment finance enters the system, it also finances all of the consumption expenditure that occurs in the subsequent multiplier process. This is because the new income in each round of that process is accompanied by an equal flow of money. This has implications for the transactions demand for money that will be considered in Chapters 6 and 7. Keynes’s revolving fund of investment finance provides the core theoretical framework for this book. Only two more major building blocks are now required. Consider again the stylised model of the revolving fund in Figure 5.3. The critical step in the circuit is the third, in which savers use their new wealth to purchase equities supplied by firms in equal value to the new capital stock. In reality, however, firms do not fund all of their investment projects by selling equity to savers, but a proportion of their capital assets remain financed by long-term debt. Further, economic agents normally choose to hold a proportion of their accumulated savings in the form of money for a variety of purposes discussed by Keynes (1936: Chapter 15) under the generic heading of ‘liquidity-preference’. As Paul Davidson first pointed out in 1968, these observations have important implications for the revolving fund analysis. These implications are the focus of the next chapter.

6 Davidson’s analysis of the revolving fund

In the analysis of the previous chapter, asset accumulation by firms was entirely funded in the long-term by issuing equities to savers and all voluntary saving was held in the form of these equities in the economy’s capital stock. Both assumptions are too simplistic, since in reality firms also use long-term debt to fund a portion of their assets and households choose to hold at least some of their savings in the form of liquid money balances. Paul Davidson (1968; 1972) was the first person to analyse the impact of this behaviour on Keynes’s theory of the revolving fund of investment finance, and the purpose of this chapter is to integrate Davidson’s analysis into the model of this book. In particular, Davidson made three alternative assumptions to Keynes that are important in the current study. First he allowed for the possibility that the marginal propensity to buy equities out of household savings might be less than one. Second he recognised that firms might fund some of their investment expenditure directly from retained profits (that is from corporate saving rather than by selling equities to household savers). Third, he allowed firms to choose to fund only a fraction of their investment expenditure externally via the issue of new equities to the public with the rest being funded by long-term debt. 1 These three considerations are the subject of the first four sections of this chapter before the final section presents the resulting two-period model that will provide the basic framework for the remainder of this book. Liquidity preference In the models of Chapters 4 and 5 income recipients in each round of the multiplier process were required to determine how much of their income would be set aside as savings. In fact, this savings decision is only the first of two choices an individual must make, as described by Keynes in The General Theory But this [saving] decision having been made, there is a further decision that awaits him, namely, in what form he will hold the command over future consumption which he has reserved, whether out of his current income or from previous savings. Does he want to hold it in the form of immediate, liquid command (i.e. in money or its equivalent)? Or is he prepared to part with

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immediate command for a specified or indefinite period, leaving it to future market conditions to determine on what terms he can, if necessary, convert deferred command over specific goods into immediate command over goods in general? In other words, what is the degree of his liquidity-preference – where an individual’s liquidity-preference is given by a schedule of the amounts of his resources, valued in terms of money or of wage-units, which he will wish to retain in the form of money in different sets of circumstances. (1936: p. 166, emphasis in original): The essence of this theory is that there are two fundamentally different types of financial assets available to wealth holders. The first type is ‘money’, which is characterised by its ability to purchase goods and services directly; that is, to act as medium of exchange. In The General Theory, money does not pay any explicit rate of interest to its holders, but provides a ‘liquidity premium’ as a result of its convenience or security as the generally accepted medium of exchange. The second type of financial asset is long-term debt (‘bonds’). Bonds do offer an explicit interest rate, but must be sold at a price which is uncertain in advance if the bondholder wants to use this store of value to make some purchase or settle some debt. Each individual’s liquidity preference is assumed to be a decreasing function of the quantity of money balances held, at least beyond a certain minimum level needed to meet expected day-to-day transactions. Under these assumptions, the wealth holder’s optimal financial portfolio allocates accumulated savings between money and bonds so that the liquidity premium on money equals the rate of interest paid on bonds. This implies that if the rate of interest rises, everything else staying the same, the quantity of money demanded falls. Translating this theory into a mathematical form, suppose that the aggregate level of money balances needed to finance day-to-day transactions depends on the value of nominal income, PY, and let the nominal rate of interest be denoted by i. Then, if the monetary authority supplies a fixed stock of money denoted M, money market equilibrium then requires that the following condition holds: M = L1(PY) + L2(i) = L(PY, i)

(6.1)

where L1, L2 and L are liquidity functions denoting respectively the quantity of money needed to satisfy the aggregate transactions demand for liquidity, the additional liquidity demanded depending on the rate of interest and a more general functional form for liquidity demand that has become standard since its introduction by Hicks (1937). 2 From a modern perspective, the theory of money market equilibrium in Equation 6.1 is unsatisfactory for a number of reasons. It is no longer plausible, for example, to suggest that the only perfectly liquid asset in the economy is non-interestbearing ‘money’ whose supply is fixed by the central bank. Financial institutions are able to supply as much ‘credit-money’ as is needed in the economy, provided that the demanders have sufficient collateral to back the bank advances. Further, if the financial sector is competitive, bank deposits will earn a market rate of interest

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that is related to the base lending rate set by the central bank. This is the core criticism of the endogenous money theorists such as Kaldor (1982) and Moore (1988c) surveyed in Chapter 3. 3 Also, as Minsky (1976: Chapter 4) emphasised in his critique of The General Theory, the above model does not explicitly include equities as an alternative financial asset. This would not matter if future profit streams could be assumed constant in nominal terms, in which case a change in the current price of equities would be equivalent to a rise or fall in their rate of return (which might then be called the rate of interest); see, for example, Keynes (1937a: pp. 117–8), who explicitly argued along these lines. This approach is not plausible, however, if inflation also increases expected nominal profits in the future (as it will do in Chapter 8). Consequently, in this study it is assumed that the non-liquid financial asset is equities in the capital stock of firms. It would be a simple matter to incorporate financial intermediaries supplying fixed interest rate bonds to households, backed by firms’ equities, but this institutional detail will not affect any of the study’s conclusions and so is omitted for the sake of simplicity. Finally, Equation 6.1 invites an important distinction between what Randall Wray (1990: pp. 162–70) has very usefully called ‘the flow demand for money’ and ‘the stock demand for liquidity’. The basis of this distinction is that agents need money to finance the day-to-day flow of economic transactions – L1(PY) in Equation 6.1 – but also choose to hold some of their stock of wealth in the form of a liquid asset – L2(i). This distinction is very important in the present study because the process analysis of the previous chapter showed that the flow demand for money to finance transactions is either provided on demand by the banking system (in the case of investment finance) or is obtained by households when they receive their income (in the case of consumption finance). This returns us to the endogenous money theory that there can never be a difference between the supply and flow demand of money, a result that will be confirmed in Chapter 7. The stock demand for liquidity, however, is more problematic. If, for example, households choose to allocate some of their saved income to increased money balances in their portfolio of financial assets, this interrupts the monetary circuit in Figure 5.3, which has implications for Keynes’s theory of the revolving fund of investment finance. The revolving fund with liquidity preference 4 Davidson (1968; 1972: Chapters 11–13; 1986) was the first to point out that households might choose to use only a portion of their saving to purchase equities, with the remainder of their saving being held as liquid money balances. In keeping with the major policy thrust of The General Theory, Davidson (1972: pp. 325–29) argued that when the supply of equities exceeds their demand as a result of households increasing their demand for money balances the monetary authorities should increase the stock of money to meet this increased liquidity preference. This section presents Davidson’s example in the framework of the process analysis of the previous chapter by allowing agents to hold some of their saving as creditmoney balances in the banking system.

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Figure 6.1 Keynes’s revolving fund with liquidity preference

Consider Figure 6.1. As in Chapter 5, firms draw on the revolving fund of investment finance to pay for real investment expenditure, I. The analysis will now introduce nominal prices into the model for the first time, so that the amount of finance required is given by: F = PI = PY0

(6.2)

where P is the price of capital goods. As recorded in Equation 6.2, this generates income for the relevant factors of production amounting to PY0 in nominal terms. This income is received in the form of credit-money – that is as a credit to the agents’ bank deposit accounts – so that in this model there is no distinction between income flows and money flows (as is the case, for example, in the standard IS–LM model). In the first round of the process, households use their new money balances to purchase consumption goods to the value of PCC1, where C1 is the real quantity of consumption in round 1 and PC is the price of consumption goods. The remainder of the income is saved, S1. Note that there is no price level associated with S1, since saving is simply a residual (that is income – and, at this stage, money – not spent). The consumption expenditure generates further income, PCY1, and so the process continues (perhaps asymptotically) until the terminal round, T, in which there is no further consumption expenditure (that is CT = 0). In every round r ⱖ 1, the following identity holds:

Davidson’s analysis of the revolving fund

PCrCr = PCrYr

69

(6.3)

and in every round r ⱖ 2: PCYr–1 = PCCr + Sr

(6.4)

These equations reproduce the core Keynesian result that investment expenditure necessarily creates an equal value of voluntary saving, since in every round of the process, r ⱖ 1, the previously identified conservation of saving principle continues to operate: (6.5) The process ends in the terminal round in which there is no further consumption expenditure (so that YT = CT = 0), and hence Equation 6.5 implies that: (6.6) In each round, the income not spent on consumption initially takes the form of increased money balances in the wealth holders’ bank accounts. Only some of that saving will be desired in the form of extra liquidity, so assume that in each round households purchase equities to increase their shareholdings by PΔEr. Note that equities are being measured in the same units as the capital stock, so that equities and the capital stock are assumed to share the same price level. 5 The remainder of their saving continues to be held in the form of increased money balances, denoted ΔHr (‘hoarding’). Again note that there is no price level associated with the residual item. The purchase of equities in each round transfers money from households back to the firms managing the new capital stock, so that the proceeds of these equity sales replenish the revolving fund of investment finance, denoted as Rr in each round. Since Equation 6.6 implies that the initial finance flow equals subsequent saving, and since saving is divided between equity purchases and increased money balances, the analysis in Figure 6.1 implies that at the end of the process (where the non-subscripted variables refer to the sum of their corresponding subscripted values): F – R = ΔH

(6.7)

For the revolving fund of investment finance to be fully self-replenishing (F = R), there must be no increase in hoarding (that is ΔH = 0 in Equation 6.7). As Davidson (1968; 1972) first analysed, if the liquidity preferences of households mean that the marginal propensity to demand equities is less than one (so that ΔH ⬎ 0), the revolving fund requires an injection of further credit-money in every period to maintain its size. If the monetary authorities fail to allow this to happen,

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investment will become constrained by the consequent shortage of finance (but note carefully, not by any shortage of saving) causing an unnecessary drag on economic growth and employment. For many post-Keynesian authors since Paul Davidson, and arguably for Keynes himself, the result in the previous paragraph represents an essential policy component in The General Theory. An increase in liquidity preference unaccommodated by the central bank reduces the quantity of finance available for investment. In terms of Keynes’s model given in Equation 6.1, this produces an increase in the rate of interest in order to ration the smaller quantity of finance to investment projects with the highest rate of return, but at the expense of lower growth and higher unemployment. This gave rise to the Keynesian prescription that the monetary authorities should always be willing to supply extra liquidity in order to keep the rate of interest at a ‘low’ full-employment level. This prescription was eventually abandoned by policymakers, in part because it failed to take into account the role of inflationary expectations in setting nominal interest rates – as explained in Friedman’s (1968: pp. 5–7) famous presidential address. A low interest rate may encourage investment, but it also encourages increased debt to finance speculative purchases of existing real assets in the hope of capital gains in an inflationary environment. Incorporating this speculative mechanism into Keynes’s model is a major achievement of this current study. Retained profits and Tobin’s q-statistic Before recasting the above process analysis into a temporal model, attention must be paid to two important details in the model that may appear unusual, but which are justified by the assumption that equities are measured in the same units as the real capital stock. The first concerns the treatment of saving in each round. In his analysis which provided the inspiration for this chapter, Davidson divided the ‘income not spent’ in the multiplier process between household saving and corporate saving, on the basis that the latter replenishes the revolving fund of investment finance directly without any need to issue new securities. In contrast, the process analysis of Figure 6.1 considers aggregate saving only – implicitly treating retained profits as an issue of new equities to shareholders. This greatly simplifies the analysis, but needs to be explicitly justified. The second detail concerns the treatment in Figure 6.1 of the purchases of equities in the new capital stock in each round, ΔEr, which are valued at the price of capital, P. If the price of equities on the stock market is greater than the price of real capital, it is reasonable to assume that firms will sell the new equities at the higher price. Thus it needs to be explained why the model is able to treat this possibility also as an increase in the quantity of equities on issue rather than as a simple increase in their price. To address the first question, consider Table 6.1, which shows the aggregate balance sheet for firms at any particular moment in time. The firms’ only asset is the physical capital stock, K, valued at the current price P. On the liabilities side, the capital assets are funded by a combination of bank advances, A, and equities on issue (shareholders’ funds), PE. Suppose now that firms earn profits that they

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retain as corporate saving, denoted Sc. Let these retained profits be used to retire bank advances (or equivalently they could appear as money on the assets side of the balance sheet, ready to finance part of the next period’s investment expenditure, without affecting the following analysis). Table 6.2 presents the balance sheet of the firms in Table 6.1 after retained profits denoted Sc for corporate saving. Because shareholders’ funds is the residual item in the balance sheet, accounting conventions record this transaction as an increase in net worth, from (PK – A) to (PK – (A – Sc)), even though the quantity of equities on issue has not changed. Effectively, each equity on issue now represents a larger share of the firms’ capital stock. If equities are measured in the same units as the capital stock, this increase in net worth represents an implicit distribution of new equities reflecting the larger proportion of the real assets no longer acting as collateral for bank debt. This is why Table 6.2 records the increase in the firms’ net worth as P(E + ΔE), since corporate saving must be imputed to the household shareholders in the form of a new equity issue in order to leave the units of measurement unchanged; that is: P⌬E = Sc

(6.8)

Turning to the second issue, suppose that during the period of analysis, Tobin’s q-statistic is greater than 1, so that the market value of each share, denoted Q, is greater than the market price of capital goods, P. 6 Suppose also that firms sell the new equities at the higher market price. This explicit new issue is denoted by ΔEn. This allows the firms to retire bank advances to the value of ΔR = QΔEn, which is greater than the value of the asset backing of the new equities, PΔEn. Thus, the net worth of the firms increases by: ΔR – PΔEn = (Q – P)ΔEn

(6.9)

This value represents a transfer from the new shareholders to the existing shareholders, who have been provided with a capital gain equal to (Q – P)ΔEn. Table 6.1 Balance sheet for firms

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The treatment of this capital gain is exactly the same as the treatment of retained profits just discussed. That is, because equities are measured in the same units as the capital stock, the capital gain is imputed to the existing shareholders in the form of an implicit equities issue, denoted by ΔEc = (Q – P)ΔEn. Thus the funding of the new capital stock is given be the following equation, as reflected in each round of the process analysis in Figure 6.1. PΔK = PΔEn + PΔEc + ΔA = PΔE + ΔH

(6.10)

It should be emphasised that this approach to the measurement of equities makes no statement about how equities are then valued in the share market. If Q ⬎ P, households are effectively deluding themselves about the true value of the real capital stock backing their equities. This may affect their economic behaviour (greater planned consumption, for example, or a higher demand for liquidity) but does not affect the underlying reality that the real capital stock is the only source of wealth in the economy (abstracting from, for example, human and environmental capital). Nor does the approach outlined in this chapter affect the basic mechanism in Davidson’s model or his policy conclusions. Any increase in the demand for liquidity should be accommodated by the monetary authorities to prevent financial constraints on investment expenditure. The main advantage of Equation 6.10 is that it allows all saving to be treated as household saving, so that liquidity preferences can be modelled as depending on the total wealth of households (rather than on marginal changes arising from non-corporate saving only, as in Davidson’s work). This greatly simplifies the algebraic analysis that follows. The supply of equities to savers This chapter began with a discussion of the two decisions made by households concerning savings and then the distribution of savings between liquid and nonliquid financial assets. In The General Theory, there is a similar two-part decision by firms, between the short-term financing of investment and the long-term funding of real capital. Consider, for example, this paragraph from Keynes: The entrepreneur when he decides to invest has to be satisfied on two points: firstly, that he can obtain sufficient short-term finance during the period of producing the investment; and secondly, that he can eventually fund his shortterm obligations by a long-term issue on satisfactory conditions. Occasionally he may be in a position to use his own resources or to make his long-term issue at once; but this makes no difference to the amount of ‘finance’ which has to be found by the market as a whole, but only to the channel through which it reaches the entrepreneur and to the probability that some part of it may be found by the release of cash on the part of himself or the rest of the public. Thus it is convenient to regard the twofold process as the characteristic one. (1937d: p. 217)

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In his post-General Theory articles concerning the revolving fund, Keynes assumed that all of the long-term funding was obtained by issuing equities, but Davidson (1972: Chapters 10–12) recognised that some of the funding might be provided instead by the banking system in the form of long-term advances. That is, firms might choose to fund only a fraction of their current investment via the issue of new securities to the public. Davidson denoted this fraction with the small letter i (p. 304), but since i is used in this book to represent the nominal interest rate, this study concentrates instead on its complement (that is 1 – i), which is denoted by the symbol d, termed the ‘marginal debt–capital ratio’. Davidson’s i and this book’s marginal debt–capital ratio, d, turn out to be crucial in the theory of inflation presented in the following chapter. To understand the role these fractions play, the reader must keep in mind Keynes’s distinction between finance and funding. Consider again the process analysis in Figure 6.1. In the first line of the process, firms undertake a certain level of investment expenditure, PI. In the aggregate this is fully financed one way or another by the banking system in the form of credit-money from the revolving fund. The marginal debt–capital ratio is not involved with this part of the theory. As the multiplier process continues, however, voluntary savings are generated that must be allocated between money balances and equities. From the firms’ perspective, this is matched by a decision about how to fund their new capital stock by a combination of long-term bank debt and new issues of share market equities. This is the part of the theory which involves the marginal debt–capital ratio, defined as the fraction of the original investment that is funded by long-term bank debt rather than by issuing new equities. In his original study, Davidson (1972: pp. 325–9) concentrated on the case in which the supply of equities to the market is greater than that demanded by households. In such a situation, households find they cannot meet their demand for liquidity, and so the natural policy response is for the central bank to buy equities in exchange for money in order to restore equilibrium without affecting the real economy. Davidson then went on to consider the converse case in which there is an excess demand for equities (which at the time of his writing he thought was less likely) and noted that in this situation ‘there is a tendency for the spotprice of securities to increase’ (ibid: p. 330). Davidson did not pursue this observation, but it turns out to be the basic mechanism for inflation analysed in the following chapter. A two-period model with an instantaneous multiplier Chapter 5 explained how the process analysis in Figure 5.4 takes place in logical time. This is also true for Figure 6.1, so that some additional assumptions are required to convert the analysis into temporal time. As discussed in Chapter 5, Keynes’s solution was to treat the income–expenditure multiplier as instantaneous. This effectively creates a two-period model in which investment takes place in one period, and an equal amount of voluntary saving takes place in the next period (see Figure 5.5). Figure 6.2 sets out the basic model produced by this assumption within the framework of this chapter.

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Figure 6.2 A two-period model of the revolving fund with credit-money

Its starting point is the previous period’s investment, P–1I–1, financed by credit flows, F–1. Note that subscripts now refer to periods in time (so that –1 refers to the previous period), rather than to rounds of the process as was the case in Figure 6.1. That investment expenditure has two impacts in the current period. First, it increases the economy’s capital stock by ΔK, initially valued at P–1ΔK = P–1I–1 in the balance sheets of the firms. The firms then decide how those capital assets will be funded in the long term by a mixture of increased long-term debt (ΔD) and increased sales of equities (PΔES) allowing finance repayment (R). Second, the investment expenditure generates an equal amount of voluntary saving through the multiplier. Households must decide how the new saving will be allocated between increased money balances, ΔH, and the purchase of new equities, PΔED. These decisions by firms and households make up the two sides of the money and equity markets, which are connected by the identities just mentioned. Note also, that the initiating investment is valued at the previous period’s price level, while the equities market is cleared by the current price level. This is what will allow this model to produce a theory of inflation in Chapter 7. The stage is now set for an algebraic model of the money market. All that is required are behavioural assumptions about how the funding and portfolio decisions of firms and households are made in each period. Chapter 7 begins this task with a simple money market model in which the demand for liquidity is derived as a simple proportion of nominal household wealth and the marginal debt–capital ratio is assumed to be a parameter. In Chapter 8, this second assumption is relaxed so that the funding decision is made with the objective of maximising shareholder funds. This produces a more sophisticated model of inflation and growth that will allow an analysis of monetary policy issues in Chapter 10.

7 A theory of credit-money inflation

Technological innovations in the twentieth century mean that virtually all countries now use bank deposits as their dominant medium of exchange, so that cheque and EFTPOS (electronic funds transfer at point of sale) accounts are the primary mechanism used by households and firms to pay for commercial transactions and to settle debts involving anything other than very small amounts (see Chapter 2). In line with these developments, this chapter presents a model in which all commodity and fiat-money has disappeared, and the only available medium of exchange is credit-money created by the lending activities of the economy’s financial institutions. Chapter 3 has explained that there are divergent views on inflation in such a world. Some have argued that such a banking system would never create an excess supply of credit-money, since unwanted bank deposits can always be eliminated by using them to retire bank loans (see, for example, Tobin, 1963; Black, 1970; Glasner, 1992). Another tradition has argued that in the absence of reserve requirements there would be no limit on the ability of banks to create deposits and hence inflation (see, for example, Gurley and Shaw, 1960: p. 255; Patinkin, 1965: p. 309; Friedman and Schwartz, 1969: p. 5). In contrast to both these views, this chapter will use the framework presented in Chapters 5 and 6 to produce a theory of positive but finite credit-money inflation. Chapter 10 will reintroduce fiat-money into the model, and it will be the means by which the central bank is able to influence interest rates in order to maintain price stability. This current chapter also marks a transition from the previous two chapters’ process analysis to analysis based on the concept of money market equilibrium. In contrast to most money market theory, however, the analysis in this chapter continues to acknowledge the close connection between real and money flows that were revealed in Figures 5.4 and 6.1. This produces a model in which the quantity theory of money turns out to have a role to play, but in a way that is significantly different from the role proposed in models such as Fisher’s (1911) equation of exchange. The presentation begins with an explanation of the model’s structure that is based on aggregate balance sheets for firms and households in the economy. These balance sheets allow the analysis to distinguish between stock values at the beginning and end of each period and flow values that take place during the interval. The model then introduces simple behavioural assumptions about the way in which households allocate their new saving between bank deposits and

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purchases of new equities in each period and about the way in which firms fund their investment expenditure. These assumptions are sufficient to produce an equation in which inflation is determined by just three items: the money–wealth ratio of households, the marginal debt–capital ratio of firms, and the economy’s supply-side growth rate. 1 This equation is a key result of this book. It reveals how inflation produces a transfer of wealth from deposit holders to shareholders that is exactly analogous to the well-known inflation tax when governments issue excessive quantities of fiat-money. The structure of the model The economy modelled in this chapter is a closed economy made up of firms and households, with no government and no central bank. The firms own the economy’s real capital stock, K, which is valued at a unit price denoted by P. The firms fund these assets with a mixture of long-term bank advances, A, and equities issued to shareholders, E. The equities are measured in the same units as the capital stock, and it is assumed for simplicity that the share market values each equity at the same price as real capital, P. Households own the equities, and also hold bank deposits, D, as their only liquid asset (which acts as the medium of exchange). Thus, the total wealth of households is given by D + PE. Since bank deposits must equal bank advances in this simple model, it follows that household total wealth equals the value of the real capital stock, PK. These assumptions are represented in the aggregate balance sheets of firms and households in Table 7.1, which are entirely uncontroversial. The next step is to consider how the process analysis of the previous two chapters affects these balance sheets. The instantaneous multiplier assumption is adopted, so that the two-period model presented in Figure 6.2 applies. This means that there are two processes at work in any given period. First, there is flow of investment expenditure that is financed by short-term credit supplied by the banking system. Second, the new capital stock created by the previous period’s investment expenditure enters into production, and so is added to the assets of the firms. Simultaneously, the multiplier process arising from the previous period’s investment operates, giving rise to an equal amount of voluntary saving. By the end of the period, firms must decide how to fund their new capital with a mixture of long-term bank advances and new equities sold to households, and households must decide how to allocate their new wealth between increased money balances (bank deposits) and purchasing new equities in the firms. Table 7.2 represents the implications of the model for the aggregate balance sheets of Table 7.1 at the beginning of the current period, where the subscript –1 denotes a value for the previous period. Consider the firms first. The model assumes that new physical capital becomes available as an input into production only in the period following its manufacture; hence at the end of any period the productive capital stock is defined excluding current investment expenditure. The purpose of this heuristic assumption is to ensure that in every period the new capital stock enters into production at the same time as its associated long-term funding decision

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Table 7.1 Aggregate balance sheets for firms and households

Table 7.2 Expanded aggregate balance sheets for firms and households

is made. Thus the firms balance sheet in Table 7.2 records that the previous period’s productive capital stock, P–1K–1, is funded by a combination of long-term bank advances, A–1, and equities on issue, P–1E–1. At the beginning of the period, the previous period’s investment expenditure, P–1I–1, is added to the firms’ assets as new capital stock, initially matched by the previous period’s investment finance, F–, on the liabilities side. During the current period, this short-term finance must be turned into long-term funding. There is a similar twofold distinction in the households’ balance sheet. Initially, the new wealth of P–1I–1 is matched on the asset side by what Moore (1988c: p. 295; 1994: p. 123) has called ‘convenience saving’. 2 This is saving not made as part of a final portfolio allocation decision, but which accrues because income is received in the form of money that is held until there is time for consumption expenditure to take place. This illustrates the more general point that ‘in a market economy, an act of saving always relates to units of money and must, at least initially, be in terms of money’ (Davidson, 1972: p. 247, second emphasis added). Once the multiplier process subsequently converts this convenience saving into voluntary saving (which takes one period under the assumptions of this model), households allocate their new wealth between equities and money deposits (held for precautionary reasons to be discussed below), as shown in the remaining items of the households’ balance sheet of Table 7.2.

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The advantage of the distinctions presented here is that they explain the symmetric decisions made by firms and households that give rise to the inflationary processes analysed in this chapter. For firms, the short-term financing of the previous period’s investment must be replaced by long-term funding made up of ongoing bank advances and new equity issues. This decision will be summarised below in the ‘marginal debt–capital ratio’, denoted by d. For households, the multiplier process creates new voluntary savings that must be allocated between bank deposits and new equity purchases. This decision will be summarised below in the ‘money– wealth ratio’, denoted by h. Within this framework, the following sections will analyse how credit-money supply and credit-money demand change during the period, depending on the chosen values of these two parameters. If d ⫽ h, then the decisions of firms and households are not initially compatible, and the model demonstrates how inflation in the price of capital goods restores money market equilibrium by the end of the period. The supply of credit-money The theory of the supply-side of the money market comes from Keynes’s revolving fund of investment finance discussed in the previous chapter. Within any period, changes in the level of credit-money in circulation depend on the net effect of providing finance for current investment, F = PI, and of repaying the previous period’s finance by selling new equities, R = PΔE. The important decision variable that will be used to model these repayments can be explained with reference to the resulting changes in the balance sheet of the firms (see Table 7.3). The real capital stock during the current period increases by P–1I–1. Initially financed in the short-term from the revolving fund of investment finance, these new assets must now be funded by a combination of increased bank advances and new equities sold to household savers. The proportion of the original investment expenditure that continues to be funded by debt at the end of the period is termed the ‘marginal debt–capital ratio’, denoted by d in Table 7.3. 3 Note that this ratio represents the proportion of the new capital stock that continues to act as collateral to the banking system as a result of only (1– d)P–1I–1 being funded by selling new equities. This suggests why the financial system is normally willing to accommodate increases in the stock demand for liquidity (at least up to a certain point) since the outstanding loans, dP–1I–1, are backed by the value of the increased capital stock. Hence, there is little risk of loss in the presence of default as long as the value of d does not get ‘too high’. 4 The analysis in Chapter 8 will consider how a representative firm might choose d to optimise the value of shareholder funds, but in this chapter the marginal debt– capital ratio will be treated as a constant parameter. Under this assumption the change in the supply of credit-money during the period, ΔMS, is given by the following: ΔMS = F – R = F – (1 – d)F–1 = ΔF + dP–1I–1

(7.1)

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Table 7.3 Changes in the aggregate balance sheet for firms

It is worth emphasising an important difference between the two components making up the increased money supply in Equation 7.1, since this difference explains how the present study departs from the endogenous money literature surveyed in Chapter 3. The first component, ΔF, is the increased money supply brought about by an increase in the financing requirements of investment; that is, the extent to which the value of investment expenditure this period is greater than its value the previous period. This is the component of money creation that has been the primary focus of most endogenous money theorists. As they predict, Equation 7.1 indicates that an increase in the price level leads to an increase in the money supply (because of the higher cost of new capital goods). In further agreement with this literature, it will shortly be shown that this component of money creation has no role to play in inflation, for the standard reason that it is matched by an equal money demand before coming into existence. The second component of the increased money supply, however, arises when investing firms choose not to retire all of their investment finance when the voluntary saving generated by the investment becomes available. Only if the aggregate value of the marginal debt-capital ratio was zero would the inability of endogenous money to be in excess supply be confirmed. Otherwise, a positive value for d creates an increase in the money supply that is not matched automatically by increased demand. This insight has not been previously considered in the literature and is what allows credit-money to cause inflation in the model of this book. The demand for credit-money The analysis of the demand-side of the money market model follows Keynes’s theory of liquidity preference, concentrating on his first two motives for households to hold positive money balances at the end of any period: the income motive and the precautionary motive. 5 The former comes from recognising that the households involved in production of investment goods during the period receive income and money flows equal to F = PI which they do not have time to spend or voluntarily save until the following period. These ‘convenience saving’ deposits are not demanded for their own sake, but exist because expenditure and income flows take time, and it is generally not convenient for income earners to convert money into equities and back again during the short gap between receiving income and purchasing consumption goods. This is especially likely to be true when creditmoney balances pay a competitive rate of interest, as they will do in this model. Thus the only purpose of this component of credit-money demand is ‘to bridge the interval between the receipt of income and its disbursement’ (Keynes, 1936: p. 195). At the end of any period, it is given by the period’s investment finance, F.

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The second reason for holding money balances is that agents live in an uncertain world, giving rise to a precautionary motive for holding a portion of total wealth as money – ‘to provide for contingencies requiring sudden expenditure and for unforeseen opportunities of advantageous purchases, and also to hold an asset of which the value is fixed in terms of money to meet a subsequent liability fixed in terms of money’ (Keynes, 1936: p. 196). Keynes himself held that this precautionary demand would be proportional to total income, but Friedman (1970: p. 202) argued persuasively that this is a stock demand for money which might therefore be expected to be a function of wealth as ‘the analogue of the budget constraint in the usual theory of consumer choice’. 6 This argument certainly makes sense in terms of the households’ balance sheet in Table 7.1, which explicitly models this demand for money as being constrained by total nominal wealth given by PK. The distinction between Keynes’s income motive and the precautionary motive also coincides with Wray’s (1990) distinction between the flow demand for money and the stock demand for liquidity discussed in the previous chapter. Following this distinction, it would be a simple matter to assume that the stock demand for liquidity is proportional to total wealth, but in fact such an assumption can be derived with a straightforward constrained optimisation model. Let the liquidity preferences of the household sector be represented in a utility function, U(H, E) defined over the quantity of the liquid asset, H, and the quantity of equities, E, and let this utility function be a constant returns to scale Cobb–Douglas function: U(H, E) = HhE(1 – h)

(7.2)

where h is a parameter. The wealth constraint is given by: H + PE = PK

(7.3)

The problem of optimising Equation 7.2 with respect to H and E subject to Equation 7.3 can be solved by using the Lagrangean function: HhE(1 – h) + λ(PK – H – PE)

(7.4)

Setting the two partial derivatives of Equation 7.4 equal to zero, and adding the complementary slackness condition, produces the following three equations (see, for example, Mills, 1984: pp. 113–19): hH(h – 1)E(1 – h) = λ

(7.5a)

(1 – h)HhE(h) = λP

(7.5b)

λ (PK – H – PE) = 0

(7.5c)

Given that the constraint is binding (that is assume λ ⬎ 0), divide Equation 7.5a

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by Equation 7.5b and simplify using Equation 7.5c to produce the following demand for liquid money balances: H* = hPK

(7.6)

Equation 7.6 states that precautionary money balances are a constant proportion, h, of nominal wealth. This parameter h will be termed here the ‘money–wealth ratio’ Combining the income and precautionary motives for holding money, the total demand for credit-money, MD, at the end of any representative period is then given by: MD = F + H = PI + hPK

(7.7)

Equation 7.7 again illustrates Wray’s distinction between the flow demand for money, which arises from ‘a willingness to expand one’s balance sheet in order to spend on goods, services, or assets’, and to the stock demand for liquidity, which is ‘a preference to exchange illiquid items on a balance sheet for more liquid items’ (Wray, 1990: p. 20; see also his 1992b article). These are precisely the two items in Equation 7.7. This distinction has a long history in economics. It can, for example, be found in Marshall’s model of money demand (cited with approval by Keynes, 1923: p. 64): Let us suppose that the inhabitants of a country...find it just worth their while to keep by them on the average ready purchasing power to the extent of a tenth part of their annual income, together with a fiftieth part of their property; then the aggregate value of the currency of the country will tend to be equal to the sum of these parts. (Marshall 1923: p. 45) With respect to Equation 7.7, if investment expenditure is 10 per cent of national income, and if the money–wealth ratio equals 0.02, then these figures would translate into the example supposed by Marshall. The following section shows that this distinction between flow and stock demands for money reconciles the standard Keynesian presumption that endogenous money cannot create inflationary pressure with this book’s theory of credit-money inflation. Money market equilibrium Assume that money market equilibrium prevails at the beginning of a period, so that the level of credit-money supplied by the financing and funding decisions of firms is willingly held by households. Equilibrium at the end of the period then requires that the change in the money supply during the interval must be matched by an equal change in money demand. The former is given in Equation 7.1 reproduced here as Equation 7.8, whereas the latter is found by differentiating Equation 7.7 to give Equation 7.9:

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ΔMS = ΔF + dP–1I–1

(7.8)

ΔMD = ΔF + hΔ(PK)

(7.9)

Notice the common term, ΔF. Setting Equation 7.8 equal to 7.9, and eliminating the common term, produces the following expression: dP–1I–1 = hΔ(PK)

(7.10)

The disappearance from this equation of the increase in the size of the revolving fund of investment finance, ΔF, reflects the standard endogenous money theory surveyed in Chapter 3 that a change in the money supply to finance expenditure has no impact on inflation because it is matched by an equal (and preceding) increase in money demand. Equation 7.10 shows, however, that this is not the end of the analysis. The left-hand side records the increase in the money supply arising out of the funding decisions of firms, whereas the right-hand side records the increase in the money demand arising out of portfolio decisions of households after a rise in their accumulated voluntary saving. 7 This last item occurs as a result of both a higher real capital stock and a higher price level as follows: dP–1I–1 = hΔPK–1 + hP–1ΔK

(7.11)

Divide both sides of Equation 7.11 by hP–1K–1, and rearrange to isolate the rate of inflation denoted by lower-case p. p = ΔP/P–1 = (d/h)(I–1/K–1) – ΔK/K–1

(7.12)

On the right-hand side of Equation 7.12, I–1 = ΔK, whereas ΔK/K–1 is just the supply-side capacity growth rate of the economy, which can be denoted by the lower-case g. Equation 7.12 then becomes: p = [(d – h)/h]g

(7.13)

Equation 7.13 is a key analytical result of this study. It presents a theory of inflation that does not depend on excess demand-side expansions in the goods market, nor on supply-side restrictions in the labour market, nor on excessive money creation by the central bank. Instead, Equation 7.13 shows a relationship between inflation and growth that depends on just two parameters: the marginal debt–capital ratio of investing firms and the money–wealth ratio of saving households. Further, it states that inflation will be zero in the presence of positive growth if and only if the marginal debt–capital ratio and the money–wealth ratio are equal. If d is greater than h, Equation 7.13 predicts a positive relationship between inflation and growth, as is often found in empirical studies of short-term movements over the business cycle.

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The economic interpretation of this result is straightforward. To achieve its supply-side growth rate, g, an economy must undertake a certain level of investment. Depending on the marginal debt–capital ratio, d, some of this investment is funded in the long term by an increase in the supply of credit-money. The investment also creates new wealth, which leads households to demand greater bank balances (for precautionary motives) depending on their money– wealth ratio, h. Only if the two ratios are equal do these effects balance, which is why their difference appears as the numerator in Equation 7.13. If the marginal debt–capital ratio is greater than the money–wealth ratio, then this excess supply of creditmoney creates an excess demand for equities until inflation increases the nominal value of wealth to the point where it stimulates exactly the right quantity of further demand for precautionary deposits. The amount of inflation required to achieve this depends on the value of the money–wealth ratio, which is why h is the denominator of Equation 7.13. Note the role played by the quantity theory of money in this theory. The quantity of money is determined by the funding decisions of firms. Only firms hold bank debt in this model, so that households are unable to use the law of reflux to retire unwanted bank balances. Nor, however, do they attempt to reduce any excess money balances by increasing their consumption expenditure, as is the normal inflation-producing mechanism implicit for example in the famous equation of exchange (that is MV = PT, where M is the nominal money supply, V is the velocity of circulation, P is the price level and T is the volume of transactions; see Fisher, 1911). Instead, the excess money balances are used to increase the demand for equities, until rising equity prices restore portfolio balance. Inflation in this model is not produced by too much money chasing too few goods, but by too much money chasing too few equities. Inflation and saving The previous section has described the mechanics of how credit-money gives rise to inflation when the funding decisions of firms are not compatible (initially) with the portfolio decisions of households. The purpose of this section is to explain the role performed by inflation in producing money market equilibrium at the end of the period. This sheds some light on a controversy in the history of economic thought centred on the classical theory of ‘forced saving’, and it is also an important preliminary step towards producing a more satisfactory treatment of the marginal debt–capital ratio in Chapter 8. The forced saving theory can be explained using the model of saving discussed in Figure 5.2, reproduced here as Figure 7.1. 8 It presents a supply curve of ‘loanable funds’ showing saving as an increasing function of the interest rate and a downwardsloping demand curve derived from planned investment. The point at which investment equals saving defines the economy’s ‘natural rate of interest’, denoted in. Within this framework, let the banking system increase the nominal money supply by extending more credit to investing firms than is justified by voluntary saving. The extra money supply, ΔMS, shifts the supply of loanable funds to the

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Figure 7.1 The classical theory of saving and investment with forced saving

right creating a new equilibrium at i’ ⬍ in. Thus a gap emerges between investment expenditure and voluntary saving shown in the diagram as the horizontal distance AB. The explanation of how this gap is filled comes from the traditional quantity theory of money, which predicts that the increased nominal money supply causes an equivalent increase in the price level. The higher price level reduces the real purchasing power of income earners in the economy, who are therefore forced to reduce real consumption. The difference in real terms between what their nominal expenditure would have purchased at the old price level and what it purchases at the higher price level is ‘forced saving’. Assuming that the aggregate output remains constant, this forced saving equals the distance AB. Of course, Mr Meade’s Relation that investment must create an equal level of voluntary saving through the Keynesian multiplier process denies the validity of the forced saving theory. Nevertheless, Equation 7.13 shows that an excess supply of credit-money created by investment finance can lead to inflation. If this inflation does not reduce real consumption in order to produce forced saving, what is its role? To answer this question, note that the model assumes that there is money market equilibrium at the beginning of the period of analysis. Given the definition of the money–wealth ratio as the proportion of the nominal capital stock chosen to be held as long-term bank deposits, this equilibrium requires: D–1 = hP–1K–1

(7.14)

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Suppose that the marginal debt–capital ratio, d, is greater than h. Under this condition, the quantity of new deposits created by the funding decisions of the firms is greater than the quantity demanded for precautionary purposes by the households at the old price level; that is: dP–1ΔK ⬎ hP–1ΔK

(7.15)

This inequality creates disequilibrium in the model. Household savers find they have greater credit-money balances than they desire. In standard models of inflation, it is often assumed that these excess money balances will be used to increase the demand for goods and services. In this model, however, the disequilibrium lies in the wealth portfolio of households, and not in their consumption-saving decisions. To restore equilibrium, households attempt to use their excess balances to purchase further equities. The supply of equities is fixed by the funding decisions of the firms, and so this action raises the price of equities and (since Tobin’s q-statistic is assumed to be held at unity) capital goods. This higher nominal value for the capital stock provides a further stimulus to the demand for nominal balances, given by the following equation. hΔPK–1 = hpP–1K–1

(7.16)

Using the formula for inflation given in Equation 7.13 and the definition for the supply-side growth rate, g, Equation 7.16 can be rewritten as: hpP–1K–1 = h [(d – h)/h]gP–1K–1 = (d –h)P–1ΔK

(7.17)

Comparing the final expression in Equation 7.17 to the inequality in Equation 7.15, it is clear that the role of the inflation is to create exactly enough extra creditmoney demand to ensure that the level of deposits created by the period’s funding decisions of firms is willingly held by households, ensuring that Equation 7.14 holds for the following period. This has an important implication for the allocation of total household saving during the period, given by S = P–1I–1. This saving can be broken down into three components, where the second line in Equation 7.18 is obtained from Equation 7.17: S = (1 – d)P–1I–1 + hP–1I–1 + (d – h)P–1P–1 = (1 – d)P–1ΔK + hP–1ΔK + hpP–1K–1

(7.18)

The three components are easily interpreted. The first item represents the purchase of new equities made available by the long-term funding decisions of the firms. The second item represents the increase in precautionary deposit demand created by the increase in the real wealth of households as a result of the new capital stock entering into production. The third item represents the increase in

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precautionary deposits induced by the higher price of capital after the inflation in Equation 7.13. The first two items are entirely reasonable, but the third item requires closer attention. Using the equilibrium condition in Equation 7.14 it can be rewritten as: hpP–1K–1 = pD–1

(7.19)

There is a well-known result in monetary economics that an increase in the price level imposes an inflation tax on nominal fiat-money to the value of pM–1, where M is the nominal supply of fiat-money. 9 Equation 7.19 is exactly analogous to that result. The term pD–1 measures the reduction in the real value of the beginningof-period precautionary deposit balances, D–1, as a result of the inflation, p. The third component of saving in Equation 7.18 therefore provides no increase in real services to the households; it simply restores the real value of their precautionary deposit balances to its pre-inflation level. Contrary to the theory that inflation creates ‘forced saving’ by households as suggested in the classical theory discussed at the beginning of this section, this theory shows that inflation reduces the real value of their current saving, since a portion of it must make up for the inflation tax on household money balances (a theory that can be traced back at least to Ricardo, 1811: p. 45). This does not mean that the reduced real value of saving disappears. Like the traditional inflation tax, the process involves a transfer from money holders (in this case the bank depositors) to the money suppliers (in this case the bank creditors). This suggests that the marginal debt–capital ratio of firms should not be treated as a parameter, but rather its value is likely to be chosen by firms in order to maximise the net advantage to their shareholders. Analysing the implications of this insight is the task of Chapter 8.

8 Inflation and growth

The model of the previous chapter produced a theory in which inflation is the result of the long-term funding decisions of firms being incompatible with the liquidity preferences of households. The latter component of the theory was derived from a reasonably standard (although simple) constrained maximisation model, but the aggregate marginal debt–capital ratio of firms was introduced as an ad hoc parameter. This is unsatisfactory, since an understanding of what influences the value of d is necessary in order to explain how monetary policy can control inflation through changes in the financial sector’s base interest rate (the aim of this study). Hence this chapter begins the task of analysing how factors such as the interest rate on bank advances, the marginal efficiency of physical capital and the expected rate of inflation interact to affect the value of the economy’s aggregate marginal debt–capital ratio. The task is not simple for the following reason. The parameter d is defined as the aggregate value of new long-term bank advances in a period (that is new bank debt excluding the credit extended to finance current investment expenditure) divided by the aggregate value of the new capital stock entering into production at the beginning of the period. The denominator of this definition is relatively straightforward to determine empirically, but the numerator is the outcome of a large number of funding decisions by individual firms who are likely to have diverse expectations about inflation and who may have very different options in terms of access to equity markets. This situation is further complicated by the existence of specialist corporations who do not produce goods and services themselves, but who issue equities and borrow debt in order to obtain funds for purchasing the equities of existing production firms in the hope of achieving capital gains through restructuring and inflation. The existence of such ‘corporate raiders’ has the effect of raising the economy’s marginal debt–capital ratio in the aggregate, without having any direct link with the real investment expenditure decisions being made each period. Faced with these problems, the strategy adopted in this chapter is to make a rather special assumption that greatly simplifies the analysis, albeit at the expense of abstracting from some important real world features. In particular, all firms in the model are assumed to be identical and perfectly competitive production firms. The perfect competition assumption is also extended to the banking system so that the difference between the rates of interest on advances and deposits is just

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enough to earn the normal rate of profit. Both of these heuristic assumptions can be challenged, although they are based on widely accepted precedents in the literature. Their great advantage is that they allow the analysis to proceed on the basis of a single representative firm, since all firms will behave identically with the one being analysed, but they also mean that issues of market power and financial speculation are lost from view. My justification for this approach is that the analysis uncovers some important economic principles that I expect will be maintained in more realistic extensions of the model. For example, the analysis shows how firms can use their money-creating ability to increase the real wealth of their shareholders. 1 The analysis then shows how this ability depends on interest rate behaviour, and it is achieved by generating a positive rate of inflation under certain conditions. Thus in order to maintain price stability, the monetary authorities must continuously adjust interest rates in order to avoid these inflationary conditions. The basic mechanism underlying the model can be explained relatively simply. The previous chapter has already shown how the aggregate funding decisions of firms determine the economy’s money stock and inflation rate. This chapter shows that the inflation increases the nominal value of corporate assets while leaving the nominal value of debt liabilities unchanged, producing a capital gain to shareholders. This capital gain is offset by interest payments on the firms’ outstanding bank advances, and so the analysis demonstrates that the optimal value of the marginal debt–capital ratio is where a small increase in its value has an equal impact on the expected inflation rate and on the nominal interest rate. If this produces a real rate of interest below the marginal efficiency of capital, competition will raise the level of investment expenditure (and hence increase the economy’s supply-side capacity growth rate) until equality is restored. The interaction of these two decisions – the optimal funding decision and the equilibrium investment decision – is what produces the model’s inflation rate and real economic growth rate. The impact of inflation on the balance sheet of firms The analysis at the end of Chapter 7 revealed how the inflation generated when d is greater than h increases the nominal value of total wealth until the excess creditmoney created by the funding decisions of firms is willingly held by households. That analysis also showed how this imposes an inflation tax, given by pD–1, on the households’ beginning-of-period precautionary deposits. This section explains how the proceeds of that tax are received by the shareholders of the borrowing firms. Consider Table 8.1, which shows the firms’ aggregate balance sheets at the beginning, middle, and end of the current period. The period begins with firms carrying over the previous period’s productive capital stock (P–1K–1, funded by a combination of long-term advances and equities on issue) and accepting new capital from the previous period’s investment expenditure (P–1I–1, financed from the revolving fund, F–1). Equation 7.14 in the previous chapter records that D–1 = hP–1K–1, and since the households’ precautionary deposits (D–1) must equal the firms’ long-term

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Table 8.1 Aggregate balance sheets for firms

advances (A–1), it follows that A–1 = hP–1K–1. This equilibrium condition has been used on the liabilities side of Table 8.1 to explain the division between long-term advances and equities on issue. During the interval, the new capital stock moves into production, and the firms convert their short-term financing into long-term funding. The mixture of new long-term bank advances and new equities is determined by the marginal debt– capital ratio, d, as shown on the liabilities side of section B of Table 8.1. If d ⫽ h, this funding mix creates a gap between the actual and the desired ratio of precautionary demand deposits to the nominal value of the capital stock. This is because the desired ratio is h but the actual ratio is given by: [hP–1K–1 + dP–1ΔK]/P–1K = h + (d – h)ΔK/K–1 = h + (d – h)g

(8.1)

Without loss of generality, let the marginal debt–capital ratio exceed the money– wealth ratio and suppose that there is positive growth in the economy. Equation 8.1 confirms that the money–wealth ratio is greater than desired, and so households attempt to reduce their excessive credit-money deposits by purchasing equities. This raises the end-of-period price of capital goods, increasing the value of the capital stock to (1 + p)P–1K, where p is the rate of inflation in capital and equity prices. The nominal values of the firms’ outstanding bank advances, however, remain the same. Hence the ex post debt–capital ratio can be rearranged as follows (where the first line incorporates the result in Equation 8.1 above): [hP–1K–1 + dP–1ΔK]/PK = [h + (d – h)g]/(1+p) = h{1 + [(d – h)/h]g}/(1+p) = h(1+p)/(1 + p) =h

(8.2)

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This confirms that the role of the inflation is to make the ex post debt–capital ratio of firms equal to the desired money–wealth ratio of households (as used to construct sections A and C in Table 8.1). In the meantime, the rise in the nominal value of the firms’ assets holding bank advances constant produces a beneficial impact on the firms’ net worth, which increases from (1 – h)P–1K–1 at the beginning of the period to (1 – h)PK at the end. Expressing this increase in real terms, it is possible to distinguish two components: {(1 – h)PK/(1+p)} – {(1 – h)P–1K–1} = (1 – h)P–1(K – K–1) = (1 – d)P–1ΔK + (d – h)P–1ΔK = (1 – d)P–1I–1 + {[(d – h)/h]g} {hP–1K–1} (1 – d)F–1 + pD–1

(8.3)

The first component, (1 – d)F–1, is the proportion of the previous period’s investment finance converted into new equities during the period, reflecting the equity-funded proportion of the new capital stock entering production. The second component measures the reduction in the real value of the beginning-of-period bank advances, D–1, brought about by the inflation, p. This component is just the inflation tax on nominal money balances analysed in Equation 7.19 of the previous chapter. Thus, Equation 8.3 shows how the proceeds of that tax are received by the firms’ shareholders, who are the ultimate beneficiaries of the reduction in the real value of the firms’ bank advances. Note that although this observation is very simple, it is also a very important economic principle. There has been a strong tendency among economists to blame all monetary inflation on the government, on the basis that a surprise inflation imposes a tax on the holders of fixed interest or zero interest government liabilities. This same principle can be applied, however, to any economic agent who is able to produce quantities of the medium of exchange. In the example of this chapter, firms that can create credit-money by drawing down bank loans using their physical capital assets as collateral also have the ability to impose an inflation tax on deposit holders. Of course, firms must pay interest on their bank advances (and interest is paid on most deposits) to compensate for expected inflation rates. Hence the following section of the analysis introduces assumptions about interest rate behaviour (and about the marginal efficiency of capital) to explain why firms cannot exploit this ability without limit. The optimal marginal debt–capital ratio The remainder of this chapter assumes that there are a large number of identical and perfectly competitive production firms, so that the marginal debt–capital ratio optimisation problem can be solved with respect to a single representative firm. The main advantage of this assumption is that it allows the representative

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firm to calculate the impact of its decision on the rate of inflation with the knowledge that all other firms are behaving in exactly the same way. Some assumption like this is essential because the theory of the previous chapter showed that inflation is determined by the aggregate marginal debt–capital ratio (given the aggregate money–wealth ratio and real growth rate) rather than by the decision of any single firm. A firm that borrows bank debt to fund new capital stock needs to pay attention to three factors. First, the new capital stock can be expected to produce a certain rate of return – termed the ‘marginal efficiency of capital’ (Keynes 1936: Chapter 11) – that will generate the firm’s operating profits. Second, the firm will be required to pay interest on its bank debt. Third, if there is inflation, the firm will receive a capital gain as analysed in the previous section. Taking these three items in turn, let the marginal efficiency of capital be denoted by e. It is standard to assume that at any given moment in time, an increase in the size of the capital stock reduces e. Given K–1, the marginal efficiency of capital therefore depends on I–1 = ΔK, and hence e is negatively related to the current rate of growth, g = ΔK/K–1. Thus e will be written as a function of g, as recorded in Equation 8.4: e = e(g), ⭸e(g)/⭸g ⬍ 0

(8.4)

Next, let ia denote the rate of interest payable by firms on bank advances, and let id be the rate of interest paid by banks to the holders of precautionary deposits. The banking system is assumed to be competitive so that ia ⬎ ib ⬎ id produces normal profits for each bank, where ib is the base interest rate set by the monetary authorities. 2 Banks are assumed to supply new advances on demand to firms, provided that the loans are backed by adequate collateral (the new capital stock), but at higher rates of interest as the firms’ marginal debt–capital ratio rises. This is to compensate the bank for the larger risk involved, based on two considerations. 3 First, increasing the proportion of new capital backed by debt reduces the excess value of the goods acting as collateral. This results in a greater risk that the collateral might be insufficient if the company fails and asset prices fall sharply during the life of the loan. Second, greater bank advances mean a higher volume of bank deposits. This reduces the liquidity of the banking system, which is exposed to a greater risk that its reserves may be inadequate for meeting any unexpected increase in the demand for withdrawals by customers (in the extreme, a run on the bank may prove costly to contain). Hence the rate of interest on bank advances is a positive function of the marginal debt–capital ratio. Further, as the marginal debt– capital ratio rises, assume that the risks, and hence the interest rate, rise more than proportionately. These assumptions can be conveniently expressed in the following form: ia = ib + i(d) ∂i(d)/∂d ⬎ 0, ∂2i(d)/∂d2 ⬎ 0

(8.5)

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Equation 8.5 simply states that the base interest rate set by the monetary authorities sets the effective floor for all interest rates on debt, and that the rate payable on bank advances rises at an increasing rate as the firm increases its marginal debt– capital ratio. Finally, if pe is the expected rate of inflation, then Equation 8.3 shows that the firm can expect to receive a capital gain during the period equal to pehP–1K–1 (see also Davidson, 1968: p. 306). At the beginning of the period, the firm’s net worth or shareholder funds equals (1 – h)P–1K–1 (from Table 8.1). The real return from the marginal efficiency of capital is equal to eP–1K–1. The interest liabilities amount to iahP–1K–1. The capital gain is pehP–1K–1. Summing these three influences and dividing by (1 – h)P–1K–1, the total expected return to each equity on issue at the beginning of the period is given by: e + {h/(1 – h)} {e + pe – ia}

(8.6)

Assume that firm managers act to maximise this gain to existing shareholders. Differentiate Equation 8.6 with respect to d and set equal to zero to obtain its maximising value, denoted d*. Since neither the marginal efficiency of capital nor the desired money–wealth ratio of households depend on the firm’s funding decision, this produces the following equality: ⭸pe/⭸d = ⭸ia/⭸d

(8.7)

Equation 8.7 is another of this book’s fundamental results, and shows the importance of marginal changes in the expected inflation rate and the rate of interest in determining the optimal marginal debt–capital ratio (and hence in determining actual inflation, given h and g). It immediately suggests, for example, that the monetary authorities would find it very difficult to control inflation if nominal interest rates are not responsive to changes in the expected rate of inflation. Consider, for example, the case in which there are regulated ceilings on interest rates. Assuming that the ceiling is a binding constraint, this would imply that ⭸ia/ ⭸d = 0 (at least in an upwards direction) and Equation 8.7 could not be satisfied as long as ⭸pe/⭸d is positive. This mechanism may have contributed to the high inflation rates experienced in many countries during the 1970s when interest rate ceilings were commonplace. The representative firm assumption and the particular algebraic forms adopted in this chapter allow the general relationship in (8.7) to be expressed more specifically. Let the firm’s expectations be ‘rational’, in the sense that expected inflation equals the inflation rate implied by Equation 7.13 in the previous chapter; that is suppose that: pe(d, h, g) = {(d – h)/h}g

(8.8)

Using Equations 8.5 and 8.8, and assuming that ⭸i(0)/⭸d ⬍ g/h ⬍ ⭸i(1)/⭸d, the condition in Equation 8.7 produces a unique d* defined by the implicit equation:

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g/h = ⭸i(d*)/⭸d

93

(8.9)

The economic intuition behind Equation 8.9 is straightforward. Suppose that the representative firm starts with a ‘low’ marginal debt–capital ratio. As the firm increases the proportion of new capital financed by bank advances, the expected inflation rate rises more quickly than the interest rate on debt, generating a capital gain that is expected to outweigh the extra interest costs. This is because the assumptions of the model are such that inflation rises at a constant rate with d, whereas the rate of interest rises slowly at low levels of d (due to low additional risk) but at an accelerating rate as d gets higher. The net gains to the firm continue until d*, at which point the marginal increase in the interest rate has risen to match the expected inflation increase, and the benefit to shareholders is maximised. Equation 8.9 reveals that the optimal marginal debt–capital ratio depends on the economy’s real growth rate, given the value of the money–wealth ratio. Hence this optimal value can be written as a function, d*(g; h), which can be depicted in a diagram with the marginal debt–capital ratio on the vertical axis of a diagram and the real growth rate on the horizontal axis (see Figure 8.1). If real growth increases – holding the money–wealth ratio constant – the partial derivative on the right-hand side of Equation 8.9 must also increase to maintain an optimal value for d. This is because a higher growth rate increases the impact of a marginal change in d on the economy’s expected rate of inflation, which must be balanced by a greater sensitivity of the nominal interest rate to the same marginal change. Since ⭸2i(d)/⭸d2 is assumed to be positive (see Equation 8.5), this requirement will be met by a higher value for d*. Hence, d*(g; h) is a positive function of g; as shown in the optimal marginal debt–capital ratio locus of Figure 8.1. Equilibrium inflation and growth To complete the model, the analysis must derive an expression for the economy’s equilibrium rate of real growth. The simplest approach is to adopt the standard Keynesian assumption that in perfect competition, ‘the rate of investment will be pushed to the point on the investment demand-schedule where the marginal efficiency of capital in general is equal to the market rate of interest’ (Keynes, 1936: pp. 136–7). Allowing for expected inflation, of course, the market rate of interest is the real interest rate; that is, the nominal interest rate paid on bank advances, ia, less the expected rate of inflation, pe. The marginal efficiency of capital is e(g), so that denoting the equilibrium growth rate as g*, Keynes’s condition becomes: e(g*) = ia – pe

(8.10)

There is a nice connection between this equilibrium condition and the optimising condition for the marginal debt–equity ratio in Equation 8.7 above. Equation 8.7 defines the value for d at which the difference between the marginal efficiency of capital and the real interest rate is maximised. If this difference is

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Figure 8.1 The optimal marginal debt–capital ratio locus

positive, however, perfect competition implies that the gap will be forced to zero by new entrants and this produces the equilibrium condition in Equation 8.10. Taken together, the two conditions imply that in equilibrium the benefit to shareholders will be maximised at a point where only normal profits on capital are being earned. Adopting the assumptions of the previous section concerning the nominal interest rate (Equation 8.5) and the rationally expected inflation rate (Equation 8.8), Equation 8.10 means that g* satisfies the following condition: e(g*) = {ib + i(d)} – {[(d – h)/h]g*}

(8.11)

The equilibrium real growth rate appears twice in this implicit equation, which makes the stability and uniqueness conditions more complicated than for d*. There are two conditions: the first ensures that some investment is profitable at g = 0, while the second states that the marginal efficiency of capital is more sensitive to changes in the rate of growth (or level of investment, given K–1) than the expected inflation rate: e(0) ⬎ ib + i(d) and ∂e/∂g ⬍ – {(d – h)/h}

(8.12)

To determine how g* responds to changes in the marginal debt–capital ratio, totally differentiate Equation 8.11 with respect to d and rearrange as follows:

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(∂e/∂g)dg* = (∂i/∂d)dd – (g*/h)dd – {(d – h)/h}dg* that is: (8.13) The second condition in Equation 8.12 ensures that the denominator on the right-hand side of Equation 8.13 is negative, whereas the optimality condition for d* in Equation 8.9 ensures that the numerator is negative/zero/positive as d is less than/equal to/greater than d*. This observation has been used to draw the equilibrium real growth rate locus, g*(d; h, ib), in Figure 8.2. It is a concave function of d, with a maximum value at d = d*, so that the equilibrium growth rate is maximised at the point where the marginal debt–capital ratio is also maximised. This makes sense. For d ⬍ d*, an increase in d causes the expected inflation rate to rise by more than the nominal interest rate. This reduces the real interest rate, inducing further investment expenditure until the marginal efficiency of capital is reduced to the lower real interest rate (the optimality condition in Equations 8.10 and 8.11). Hence equilibrium real growth rises with d. For d ⬎ d*, however, an increase in d leads to a smaller increase in the inflation rate compared with the interest rate on bank advances, and so the real interest rate and the real growth rate fall. Thus the real rate of interest is minimised, and the equilibrium growth rate is maximised, at d*.

Figure 8.2 The optimal marginal debt–capital ratio and equilibrium growth rate

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The point of intersection between the two curves in Figure 8.2 simultaneously determines the economy’s equilibrium real growth rate, denoted g°, and the optimal marginal debt–capital ratio, d°, at that equilibrium growth rate. From Equation 7.13, these two variables and the money–wealth ratio determine the economy’s equilibrium inflation rate, p°, which is given by: p° = [(d° – h)/h]g°

(8.14)

This equation states that the inflation rate will be negative, zero, or positive depending on whether d° is less than, equal to, or greater than h (assuming positive growth). The nominal interest rate on bank advances in equilibrium is then found from Equation 8.5; that is: ia° = ib + i(d°)

(8.15)

From the equilibrium condition in Equation 8.11, the marginal efficiency of capital equals the real interest rate defined as the difference between Equations 8.15 and 8.14, so that e(g°) = ib + i(d°) – [(d° – h)/h]g°

(8.16)

Thus, the model is complete. Productivity shocks and the Phillips curve The main purpose of this chapter’s model is to demonstrate how monetary policy is able to intervene to maintain price stability in the presence of inflation pressures due to d° being greater than h. This will be the subject of Chapter 10. To complete this chapter, however, the workings of the model can be illustrated by using it to analyse the consequences for inflation and growth if the economy experiences a series of small technological shocks that affect the marginal efficiency of capital. The choice of this example is not entirely arbitrary, since there is a well-established ‘real business cycle’ literature suggesting that unobserved technology shocks are important in explaining variations in key macroeconomic variables such as real growth, unemployment, inflation and the money stock. 4 Figure 8.3 has been drawn to represent an initial equilibrium in which there is positive inflation, since d° is greater than h on the vertical axis, and g° is positive on the horizontal axis. Suppose that a positive technological shock occurs which increases the marginal efficiency of capital for any given value of g. If nothing else changes, the higher e is now above the prevailing real rate of interest so that there is an incentive for firms to increase investment expenditure at any given value of d. Thus the equilibrium real growth rate locus, g*(d; h, ib), shifts to the right, to g*’(d; h, ib). Figure 8.3 reveals that a new equilibrium emerges, in which d’ is greater than d° and g’ is greater than g°. Since h is held constant by assumption, it follows from Equation 8.14 that the equilibrium inflation rate must also be

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Figure 8.3 Exogenous shocks to the marginal efficiency of capital

greater. In short, the positive productivity shock increases both the economy’s growth rate and its inflation rate. Hence if an economy experiences a series of productivity shocks (which cannot be directly observed), this would lead to a positive relationship between output growth and inflation (an example of the famous Phillips curve), but it would be incorrect to infer from this that the inflation was either causing or being caused by the output growth. Both would be the result of a third factor – the productivity shocks. The model outlined in this chapter suggests that to maintain price stability the monetary authorities must ensure that the optimal marginal debt–capital ratio equals the economy’s desired money–wealth ratio. An analysis of how this can be achieved by manipulating the base interest rate, ib, will be the subject of Chapter 10, but first the following chapter shows that the process analysis framework presented in this book can be used to analyse the traditional example of fiatmoney printed to fund ongoing fiscal deficits. This is important, since fiat-money will be reintroduced in Chapter 10 in order to give the monetary authorities some leverage over the base interest rate.

9 Fiscal deficits and inflation

The model of monetary inflation derived in the previous chapters of this book makes no reference to either fiscal policy or fiat-money issued by the state. Yet throughout history budget deficits financed by central bank money creation have often been a cause of sustained inflation, and so it is desirable to explore whether the framework of this book is able to shed any insight into such episodes. Indeed, this chapter will show that there are a number of similarities between a government budget deficit financed by fiat-money creation and private sector investment expenditure financed by credit-money creation. Budget deficits have a similar multiplier impact on aggregate income and saving, for example, and the associated money flows can be represented in the familiar pattern of initial short-term finance that is subsequently repaid by the sale of long-term securities. If a government has access to central bank finance, however, there are also important differences. It may mean, for example, that the government is not subject to normal banking discipline concerning loan collateral and risk assessment, so that the initial finance may be used for consumption expenditure rather than capital formation. This has implications for the government’s balance sheet and for the sustainable growth path of its public debt. Also, because government securities are normally accepted as an appropriate reserve asset for the banking system, rising levels of public debt are likely to facilitate the credit-money creation processes described in Chapter 3. This has implications for the central bank’s task of maintaining price stability. The chapter begins with a process analysis of a budget deficit initially financed by central bank credit and then funded by a combination of public debt sales and fiat-money. This section draws out the many parallels with the processes analyses of earlier chapters. The next section then considers some of the differences that make budget deficits a special case, drawing on a framework described as a ‘conceptual’ public sector balance sheet (since it includes an item reflecting the state’s sovereign right to tax). This allows some mathematics to be introduced into the model in order to derive the standard formula for the inflation tax, and to discuss its relationship to the impact of inflation on income earners and savers identified in Chapters 7 and 8. The final section presents a preliminary combined model that includes both fiat-money and credit-money in the household sector’s portfolio of assets. This prepares the way for Chapter 10, which analyses how monetary policy can operate through the financial system’s base interest rate to control the rate of inflation.

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A process analysis of a budget deficit The government’s budget deficit during a given period is the difference between its expenditure and revenue. The expenditure includes real expenditure on consumption goods and investment goods, denoted G valued at the unit price denoted PG, and interest liabilities on its outstanding public debt, denoted B for bonds. The rate of interest on government bonds is denoted by ig, which under some circumstances may also be the base interest rate (ib) of the banking system if government’s bonds are the economy’s principal riskless financial asset. Government revenue comes from taxation, net of offsetting non-interest transfer payments such as social security income support, which is denoted by T. If the government operates a budget deficit, standard Keynesian analysis recognises that this sets in motion an income–expenditure multiplier process that will generate extra tax revenue and so reduce the initial budget deficit. To incorporate this into the analysis, let T0 represent the tax revenue from all other sources (net of transfer payments) excluding the tax flows arising out of the multiplier process initiated by the deficit. This means that the process analysis can begin with an initial budget deficit, Z0, defined by: Z0 ≡ PGG + igB – T0

(9.1)

The symbol, Z0, is used rather than Y0 in Equation 9.1 to acknowledge that the budget deficit is not entirely expenditure on gross domestic product (as was investment expenditure in Chapter 5) but includes transfer payments and tax receipts. The resulting process analysis is presented in Figure 9.1 below. The initial budget deficit must be financed in the short-term, and in keeping with the literature on this subject it is assumed that the finance, F, is provided by the central bank in the form of fiat-money (which will be denoted with the symbol N, for ‘notes and coins’). 1 The initial transaction gives rise to three flows in the first round of the process in Figure 9.1: direct and indirect tax payments, T1; voluntarily saving, S1; and consumption expenditure, PCC1. Note that only the last of these involves goods and services, and so the first two items do not have associated price levels. The tax payments return cash to the government, which can be used to retire some of the initial deficit finance, RT1. Part of the saving is used to purchase newly issued long-term public debt, ΔB1, which also returns money to the government for finance repayments, RB1. The remainder of the saving increases the private sector’s holdings of fiat-money, ΔN1. In the meantime, the expenditure on consumption goods creates an equal amount of new income, PCY1, which initiates a second round of flows. The process continues in this way until a round occurs (perhaps asymptotically) in which there is no further consumption expenditure, and hence no further income generation. Note that Figure 9.1 makes no special assumptions about taxation or consumption in each round. In particular, neither the marginal tax rate nor the marginal propensity to consume is required to remain constant throughout the process, as is the case in most textbook treatments. Nevertheless, statements can

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Figure 9.1 Process analysis of a budget deficit

be made about the overall result by examining the identities in each round, as was done in Equations 5.1–5.5 in Chapter 5. Consider the following equations, which are true for all rounds of the income–expenditure process, r ⱖ 2. S1 ≡ Z0 – T1 – C1

(9.2)

C1 ≡ Y1

(9.3)

Sr ≡ Yr – 1 – Tr – Cr

(9.4)

Cr ≡ Yr

(9.5)

Equations 9.2 and 9.4 define saving as after-tax income not spent in each round, whereas Equations 9.3 and 9.5 state that consumption expenditure generates new income. Incorporating the definition of the initial budget deficit in Equation 9.1, these identities then imply that at the end of any round for r ⱖ 1:

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(9.6) Equation 9.6 is the equivalent of the saving conservation principle found in earlier chapters. It states that in each round of the process, the current state of the budget deficit (that is the initial deficit less all tax revenue flows during the process so far) equals accumulated voluntary saving (the first item on the righthand side of Equation 9.6) plus the current period’s new income that has not yet had time to be spent or voluntarily saved (Yr, termed convenience saving in earlier chapters). Denote the total budget deficit at the end of the process by Z, defined as follows: (9.7) where T refers to the terminal round in which there is no further consumption expenditure. By definition, YT = 0, so that Equations 9.6 and 9.7 reveal that the process concludes with exactly sufficient voluntary saving to match the total budget deficit; that is: (9.8) Equation 9.8 is a standard and very important Keynesian result, which denies that a budget deficit absorbs private sector saving that would otherwise be available to finance investment, as is sometimes claimed. 2 Rather, budget deficits necessarily create an equal amount of voluntary saving. The parallel to Keynes’s (1937c, d) discussions concerning the relationship between investment and saving is obvious, and indeed it was this observation that led Tobin (1965) to argue in a famous paper that the government should aim to operate a budget deficit calculated to generate and absorb just enough extra saving to ensure that the economy grows at a rate sufficient to maintain full employment. Consider now the financing aspects of the deficit. In each round, the voluntary saving is allocated between purchases of government debt and increased holdings of fiat-money. Since the level of voluntary saving at the end of the process equals the aggregate budget deficit, this gives rises to another well-known relationship known as ‘the government budget restraint’, which states that a budget deficit must be funded by a combination of increases in the stock of base money, ΔN, and increases in the stock of public debt, ΔB. 3 In the notation of this study, this relationship is stated in Equation 9.9. Z = ΔN + ΔB

(9.9)

Thus any initial expansion in the monetary base to finance a deficit can always be retired by selling public debt to savers in order to absorb that

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fiat-money (Equation 9.9). In principle, therefore, budget deficits need not be inflationary (assuming, of course, that the public debt remains an acceptable risk-free financial asset). This optimistic conclusion, however, must be tempered by some important practical considerations that have had a long and thorough treatment in the economics literature, which will be discussed in the following section. Budget deficits and the public sector balance sheet In Chapters 6, 7 and 8, the process analysis of investment expenditure was supplemented with balance sheet analysis to define some key parameters (notably the marginal debt–capital ratio) and draw important conclusions. The same procedure can be adopted in the context of budget deficits, but there is a critical difference in the public sector arising from its ability to levy taxes. This is a very important asset that ought to be included in a discussion of public sector net worth. For example, it is conceptually possible to estimate the maximum value of taxes that could be collected in all future years, and to calculate the net present value of this tax flow. A similar calculation could obtain the net present value of the government’s obligations to provide certain core public services (defence and justice, for example). The difference between these two concepts would represent the value of the net intangible asset that arises from the government’s sovereignty. No government presently calculates such a figure, of course, but the important idea is that the determination of any limit on a government’s ability to borrow must include an assessment of its ability to levy future taxes. 4 Consider therefore Table 9.1 which shows a conceptual public sector balance sheet incorporating this argument. The first line of the balance sheet records the government’s stock of public capital goods, accumulated from past public investment expenditure, and its level of public debt liability, accumulated from past fiscal deficits. The second line contains the central bank’s assets (which may include a portion of the public debt as well as private sector financial securities) and liabilities (including, most notably, the quantity of fiat-money on issue). The difference in the rates of return on the central bank’s assets and liabilities – where the latter may be zero in the case of fiat-money – generates seigniorage income for the government. The third line contains two concepts labelled here as ‘Net sovereignty assets’ and ‘Net worth’. The former refers to the conceptual net asset arising from the government’s sovereign right to levy taxes and its sovereign duty to provide core public goods. Net worth is the residual item in the balance sheet that must remain positive for sound public finance. Within this framework, consider the impact of a budget deficit funded in the long-term by the sale of government securities to private sector savers. On the liabilities side of Table 9.1, public debt is increased by the value of the deficit. Whether this is sustainable depends first on the nature of the deficit expenditure. If the deficit arises from investment expenditure on capital goods that are expected to earn a rate of return no less than the interest rate on public debt, then the value of ‘Public capital goods’ increases by an equal or greater amount on the assets side

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Table 9.1 Conceptual public sector balance sheet

of Table 9.1 as public debt on the liabilities side. Such a deficit is therefore sustainable, and in this instance the analysis is no different from the analysis of private sector investment expenditure in Chapter 5. This possibility has been generally overlooked in the literature on public debt sustainability (Eisner, 1989, is an important exception), which is perhaps surprising given Keynes’s own emphasis on public investment as his preferred instrument of state intervention in The General Theory (1936, especially pp. 164 and 377–81). If, however, the deficit is caused by consumption expenditure or transfer payments, then the only collateral offered to the private sector for the public debt is the state’s ability to levy taxes in order to finance its interest and principal obligations (Barro, 1974: p. 1101, fn. 6). This is not necessarily unsustainable, however. The ability to raise tax revenue is likely to increase at least in proportion with gross domestic product, so that a rising level of public debt is sustainable if its growth rate is no greater than the growth rate of nominal gross domestic product (where the latter might be facilitated by deficit expenditure on certain items for the public good, such as infrastructure, education and health; see, for example, Smithin, 1989; Pressman, 1994). In terms of Table 9.1, this would imply that the value of net sovereignty assets is rising at least as quickly as public debt, and so again net worth would not be diminished. 5 If instead there are constant primary deficits (that is constant fiscal deficits excluding interest payments) and the real interest rate is greater than the rate of real economic growth, the government’s assets will not rise to match its new liabilities, and consequently the residual item in its balance sheet (net worth) must fall in value. Successive deficits of this type might be possible for a time, but must eventually lead to a crisis of confidence in the public debt instrument as savers come to judge the interest obligations to be beyond the government’s ability to pay (as net worth moves closer and closer to zero). Buiter and Kletzer (1992), for example, suggest that there might be some upper bound to the ratio of public debt to nominal income, beyond which no more government securities can be sold. Under these circumstances, ΔB comes to equal zero, and Equation 9.9 reveals that budget deficits cause permanent increases in the money supply – and hence inflation – as first pointed out in the famous ‘unpleasant monetarist arithmetic’ of Sargent and Wallace (1981). Even if confidence in its debt instrument is sound, however, the government can choose to finance only part of its budget deficit by selling securities to the public, just as the private sector in Chapters 7 and 8 could choose to finance only

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a portion of its investment expenditure by selling equities. The exact method by which the government ‘monetarises’ a portion of its debt depends on the institutional arrangements between the Treasury and the central bank, but its essence can be modelled without loss of generality by assuming that the government instructs the central bank to purchase a portion of its newly issued securities, thus removing them from the public domain. This transaction increases by an equal amount the respective values of central bank assets and liabilities in the second line of Table 9.1, but it also means that in the public sector’s consolidated accounts the monetarised portion of the government’s fiscal deficit incurs no future interest liabilities (assuming a zero rate of interest on fiat-money issued by the central bank). The following section analyses the implications of this in a mathematical model of the market for fiat-money. The government’s inflation tax The process analysis in Figure 9.1 can be used to construct a mathematical model of supply and demand for central bank liabilities. The time structure of the model will be similar to that introduced at the end of Chapter 5; that is, it will be assumed that the government operates a budget deficit in one time interval, and in the following time interval the multiplier process creates sufficient tax flows and saving flows to fund that deficit. It would only clutter the algebra to consider the multiplier-induced tax flows separately, and so the algebra will define the first interval’s budget deficit as (PGG + igB – T0) plus the tax revenues that are generated by the associated multiplier process in the second interval (that is Z will be used rather than Z0). In this second interval, the government must decide what portion of the deficit will be funded by the central bank, and what portion will be funded by selling government securities to savers in the economy. Let the proportion of the deficit that is funded with central bank liabilities be denoted by m, the monetarised deficit ratio: ΔN = mZ–1

(9.10)

Equilibrium requires that this change in this supply of fiat-money must be willingly held as a stock by agents in the economy. Assume that this stock demand for fiat-money is a proportion, n, of the economy’s wealth, again given by the nominal value of the capital stock. 6 This is recorded in Equation 9.11: N = nPK

(9.11)

Before setting the partial derivative of Equation 9.11 equal to Equation 9.10, it is necessary to introduce one more piece of notation. Let the ratio of the nominal budget deficit, Z–1, to the increase in the economy’s capital stock valued at beginning-of-period prices, P–1ΔK, be denoted by lower case z–1, as recorded in Equation 9.12:

Fiscal deficits and inflation

z–1 = Z–1/P–1I–1

105

(9.12)

This variable turns out to be important, since the budget deficit introduces fiatmoney into the economy, whereas the investment expenditure determines changes in the demand for fiat-money by increasing a household’s real wealth. Setting the derivative of Equation 9.11 equal to Equation 9.10, using Equation 9.12 to simplify, and then solving for the inflation rate, p, produces the following expression (recalling that g is the capacity growth rate of the economy, ΔK/K–1): p = [(mz–1 – n)/n]g

(9.13)

Equation 9.13 states that the rate of inflation is higher when the proportion of the deficit monetarised is higher, when the ratio of the deficit to private sector investment is higher, when the ratio of fiat-money demand to wealth is lower and when the economy’s growth rate is higher. Following Keynes (1923: pp. 37–53), the inflation generated in Equation 9.13 is known as the inflation tax. 7 By issuing fiat-money, the government is able to consume resources beyond its current income without incurring an equal amount of interest-bearing debt. In this sense, the privilege provides a special type of tax revenue, whose real value is given by Δ(N/ P), which can be broken down into two components (see, for example, Auernheimer, 1974: p. 600): Δ(N/P) = ΔN/P–1 + pN–1/P–1

(9.14)

Equation 9.14 records that the government obtains money issue revenue from two sources. First, any increase in the real demand for fiat-money (perhaps caused by an increase in real wealth through private or public sector investment) allows the government to obtain resources in exchange for supplying the required extra currency. Second, inflation reduces the real value of fiat-money, and so the private sector must give up a portion of their current saving to acquire further currency to restore the desired balance. Both sources of revenue are examples of seigniorage (reducing the quantity of real government debt that must be issued to the private sector), but the second does not provide any additional benefit to the holders of currency (who sacrifice real resources but end up with the same real value of currency as before). This is why the second component on the right-hand side of Equation 9.14 is described as an inflation tax imposed on currency holders, where the tax base is the real value of currency, N–1/P–1, and the tax rate is the inflation rate, p. Whenever the state resorts to the inflation tax, of course, ‘the public discover that it is the holders of notes who suffer taxation and defray the expenses of government, and they begin to change their habits and to economise in their holdings of notes’ (Keynes, 1923: p. 41). Incorporating some form of this behavioural assumption into the currency demand function of Equation 9.11, and substituting the result into the first component of Equation 9.14, would derive an expression for the revenue-maximising rate of inflation (see, for example, Siegel,

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1981). This insight has initiated a large literature exploring, for example, the impact of different assumptions concerning inflation’s influence on items such as real income tax flows, and whether imposing such taxes are optimal from a social welfare point of view. 8 An unfortunate consequence of this focus on the incentives for inflation from a public finance perspective, however, is that it has become commonplace to presume that therefore all monetary inflation is generated by the government. In Auernheimer’s important paper, for example, the author wrote, ‘I also assume, as it is usually done, that government is the only issuer of money’ (1974: p. 600, emphasis added), and Chapter 1 of this study has given other examples. In fact, this chapter suggests that the process of government-created monetary inflation is a special case of the more general process of monetary inflation analysed in Chapters 6, 7 and 8. For example, the inflation tax in Equation 9.14 has already appeared in Equations 7.19 and 8.3 as the value of the transfer from savers to capital owners that arises when there is inflation in the creditmoney economy. Also, Equation 9.13 above is very similar to Equation 7.13; for example, both equations have a positive Phillips curve relationship between inflation and growth whenever prices and real output are both rising. This similarity can be made particularly clear in a model that includes both fiat-money and credit-money as the medium of exchange. A combined model of fiat-money and credit-money As a first approach towards integrating fiat-money and credit-money within a single model, suppose that the two types of money are perfect substitutes for each other in household portfolio decisions, and that fiat-money plays no particular role in the financial system. These assumptions allow the stock demands for fiatmoney, N, and credit-money, M, to be combined into a single function of nominal wealth as follows (where l is the proportion of nominal wealth desired to be held in liquid form): (N + M) = lPK

(9.15)

The change in the supply of fiat-money is proportional to the size of the fiscal deficit (Equation 9.10 above), which using the definition of the ratio of the deficit to the level of capital formation in (9.12) can be written as: ΔN = mz–1P–1I–1

(9.16)

The change in the supply of credit-money comes from Chapter 7, with one small alteration. In Chapter 7 only the private sector engaged in capital formation. In this chapter, however, part of the government’s fiscal deficit may be backed by public sector investment. Therefore, let j–1 denote the proportion of the previous period’s total investment that is undertaken in the private sector. Only this portion is relevant for the private sector’s funding decisions involving credit-money, so that the formula for its change is given by:

Fiscal deficits and inflation

ΔM = dj–1P–1I–1

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(9.17)

Differentiating Equation 9.15, and substituting Equations 9.16 and 9.17 into the result, produces the following expression for the rate of inflation, p, as a function of the supply-side capacity growth rate, g: (9.18) This is easily interpreted. In the brackets in the denominator mz–1 and dj–1 represent the increase in fiat-money and credit-money, respectively, both measured in relation to the aggregate increase in the economy’s capital stock (and hence the increase in real wealth). An interesting case emerges, for example, if the government’s fiscal policy sets current expenditure equal to current revenue, so that only capital expenditure is funded by public debt and fiat-money issue. Under this circumstance, z–1 = (1 – j–1) and the brackets in Equation 9.18 is simply the weighted average of the monetarised deficit ratio, m, and the marginal debt– capital ratio, d. If this weighted average is greater than the liquidity preference ratio, l, inflation restores money market equilibrium by raising the nominal value of household net worth until the excess stock of money comes to be willingly held. If fiat-money and credit-money are perfect substitutes, therefore, there is little scope for monetary policy to control inflation. Any policy to reduce the rate of growth of fiat-money, for example, can always be offset by a higher rate of growth of credit-money. The traditional answer to this problem is to suggest that fiatmoney and credit-money are not in fact perfect substitutes because fiat-money acts as ‘base money’ to the financial system (see Chapter 2). If regulations or prudent business practice requires bank deposits to be a fixed ratio of the financial system’s quantity of base money, then controlling this quantity also imposes a ceiling on the quantity of credit-money. Endogenous money theorists have been highly critical of this analysis (see Chapter 3), and so Chapter 10 presents an alternative mechanism in which the monetary authorities are able to discipline the rate of credit-money creation, not through quantity adjustments but by adjusting the financial system’s base interest rate.

10 Monetary policy and price stability

Chapter 1 of this book has described how central banks around the world have been given clear mandates to devote monetary policy to the principal (and sometimes single) goal of maintaining stable prices. This has successfully restricted the ability of governments to initiate inflation for their own purposes – economic or political – but this books argues that there may be other costs in controlling inflation through monetary policy alone if excess monetary growth is initiated by the private sector rather than by the government. In particular, previous chapters have developed a model in which the private sector is able to create an excess money stock by adopting a long-run marginal debt–capital ratio in excess of the economy’s aggregate money–wealth ratio. Hence, if the central bank is to maintain price stability, its policies must seek to control the money stock indirectly, by influencing the funding decisions of investing firms. The main purpose of this chapter is to analyse how this is done, and then to consider whether supplementary policies are available that would allow price stability to be achieved at a lower cost to economic growth. The chapter begins by describing New Zealand’s reform of its Reserve Bank in the late 1980s, and further monetary policy developments in the 1990s. New Zealand was a pioneer in inflation targeting, and so this is of some historical interest, but it also provides important insights into more general problems central banks have faced in implementing policies to achieve inflation targets. In particular, it explains how New Zealand first adopted monetary base measures as its principal instrument of monetary policy, but these became less effective over time as financial institutions economised on their need for central bank reserves. Consequently, the Reserve Bank adopted an official cash interest rate system in 1999 – bringing it into line with other central banks – in which the stated objective of interest rate changes is to keep aggregate expenditure growth as close as possible to capacity growth. This framework relies on a basic assumption that monetary policy has no impact on the supply-side growth rate, and that there will be price stability as long as there is no excess demand in the aggregate goods market. The remainder of this chapter challenges these assumptions by incorporating monetary policy into the model of Chapters 7 and 8. In that model, inflation occurs when the marginal debt–capital

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ratio is higher than the economy’s money–wealth ratio, and the second section of this chapter shows how a policy-induced increase in the base interest rate leads to a lower maximising value for the marginal debt–capital ratio, but it also reduces the economy’s equilibrium supply-side growth rate. Both factors reduce the inflation rate. The analysis also shows that if the central bank’s actions lead to an increase in the responsiveness of nominal interest rates to increases in the marginal debt–capital ratio, then the inflation target can be reached at a higher growth rate. This paves the way for a section exploring how a two-instrument policy framework might be designed to maintain price stability with the minimum of disruption to investment and growth, providing a theoretical justification for what Stiglitz (1997) has called a ‘cautious expansionism’ approach to monetary policy. All of this analysis takes place within a model of inflation in the price of equities, and so the chapter finishes with a section on how equity prices are related to the price of consumption goods (since inflation targets typically refer to consumer prices). The Reserve Bank of New Zealand Act 1989 On 14 July 1984, a general election in New Zealand produced a landslide defeat for the National Party, which had been led in office by the indomitable Sir Robert Muldoon since 1975. Sir Robert’s approach to economic management was based on heavy-handed state intervention in almost every domestic market (either through regulation or as the principal supplier) as well as widening fiscal deficits and erratic monetary policy. Figure 10.1, which shows the annual growth rate of New Zealand’s broad money supply for financial years ending March from 1959/60 to

Figure 10.1 Broad money supply nominal growth, New Zealand, 1959/60 to 1998/9. E represents a financial year containing a general election. Source: Dalziel and Lattimore (1999: Figure 5.1).

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1998/9, illustrates this last point particularly well. 1 The graph marks the financial years containing general elections (which in New Zealand normally take place in a November) with an E. This shows that every election year from 1963/4 to 1984/ 5 saw a sharp increase in the growth rate of the money stock (particularly during the 1970s) followed by a sharp slowdown in growth in the next financial year (except after the 1984 election, when financial deregulation led to a further increase in money supply growth). Thus there is clear evidence of a ‘political business cycle’ in New Zealand before 1984 as monetary policy was manipulated in attempts to promote electoral advantage to the incumbent government rather than to maintain macroeconomic stability. The reason why the government was able to implement such a strategy can be found in the legislation governing monetary policy at the time. Section 8 of the Reserve Bank of New Zealand Act 1964, as slightly amended in 1973, contained the following clause describing the purpose of monetary policy: 2 For the purposes of this Act, the Minister may from time to time communicate to the bank the monetary policy of the Government, which shall be directed to the maintenance and promotion of economic and social welfare in New Zealand, having regard to the desirability of promoting the highest level of production and trade and full employment, and of maintaining a stable internal price level. There are two points to note about this clause. First, the authority for determining monetary policy was given to the Minister of Finance, so that the Reserve Bank had no operational autonomy but was obliged to implement policy directives from the minister. When the snap election was called in 1984, for example, there was an immediate run on the New Zealand dollar. The Reserve Bank strongly urged the Finance Minister (who was also Prime Minister) to authorise a devaluation under New Zealand’s fixed exchange rate regime at the time, but Sir Robert refused, and he instructed the bank to support the dollar by entering into unhedged forward exchange contracts. When the dollar was devalued immediately after the election, the total cost to the taxpayer of defending the dollar during the four-week election campaign was more than 2 per cent of the year’s gross domestic product (Dalziel and Lattimore, 1999: p. 23). Second, the old legislation provided two broad goals for monetary policy: a real objective (the highest level of production and trade and full employment) and a nominal objective (maintaining a stable internal price level). As captured in the famous Phillips curve, these goals are generally contradictory for any given level of inflationary expectations, providing scope for the government to implement any monetary stance that suited its electoral purposes. Inspired by analysis such as the Kydland-Prescott model presented in Figure 1.2 of this book, New Zealand policymakers came to the view that the conflict in the statutory objectives of monetary policy should be resolved in favour of a single focus on achieving and maintaining price stability. 3 By June 1988, the Reserve Bank was speaking about achieving price stability ‘consistent with a small positive

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measured inflation rate, in the order of 0–2 percent’ (Reddell, 1988: p. 82, fn. 1). A month later, the Minster of Finance announced in his annual budget speech that he intended ‘to require the Reserve Bank to formulate and implement policies that make the maximum possible contribution to achieving and maintaining a stable general level of prices’ and to introduce a reformed Reserve Bank Act along these lines (Douglas, 1988: pp. 10–12). In December 1989, the reforms were passed without a dissenting vote in the House of Representatives, coming into effect on 1 February 1990. Section 8 of the new act now consists of a single sentence: The primary function of the Bank is to formulate and implement monetary policy directed to the economic objective of achieving and maintaining stability in the general level of prices. In support of this objective, the Treasurer (on behalf of the Government) and the Governor of the Reserve Bank must agree on a ‘Policy Targets Agreement’ (generally known as the PTA), which indicates what outcome is consistent with achieving stability in the general level of prices. This agreement is renegotiated whenever the Governor is appointed or reappointed (normally for a term of five years) or by mutual agreement. It has three key components: 1 a numerical inflation target, currently defined to equal 0–3 per cent annual increase in the consumers price index; 2 a recognition that the bank is not obliged to offset the direct impact of significant supply-side shocks such as terms of trade movements, indirect tax changes and natural disasters; and 3 an explicit obligation for the bank to be fully accountable for its judgements and actions in implementing monetary policy, which are required to be sustainable, consistent and transparent. In keeping with this last requirement, the Reserve Bank publishes a Monetary Policy Statement approximately every three months, which is referred to Parliament and reviewed by the latter’s Finance and Expenditure Select Committee. This basic elements of this policy framework are now widely accepted by many central banks. 4 Where New Zealand departed from general international practice – at least until March 1999 – was its choice of policy instruments. In 1985, the Reserve Bank introduced ‘primary liquidity’ as its operating target, defined to equal the quantity of settlement cash balances held by financial institutions at the Reserve Bank plus the quantity of short-term government securities on issue that were discountable by the bank on demand. This was the closest New Zealand came to targeting a monetary aggregate, but the experiment was short-lived (although primary liquidity targets continued to be published until December 1987). There was also a brief attempt in 1985 by the government to publish guidelines based on nominal GDP targets before the bank adopted settlement cash targets as its main instrument of signalling changes in its desired monetary policy stance from 24 March 1986.

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Settlement cash refers to deposit balances held by registered financial institutions at the Reserve Bank in order to settle net obligations to each other at the end of each business day (and in real time for large transactions). These accounts are used for this purpose because the special characteristic of central bank liabilities as ‘legal tender’ means they are acceptable as the principal risk-free financial asset for settling outstanding debts (see, for example, Beaumont and Reddell, 1990; Dale and Haldane, 1993; King, 1994). The Reserve Bank requires these accounts to be continuously in credit, thus creating a precautionary demand by each member bank for settlement cash. The initial daily cash target in 1986 was $50 million, and over the next few years the bank used changes in this target to influence monetary conditions. As the economics literature on the topic would predict (see, for example, Goodhart, 1984: Chapter 5 ; Chick, 1986; Moore, 1986), innovation by financial institutions reduced their requirement for cash balances, so that by the end of 1991 the daily target had fallen to $20 million. This was just sufficient for signalling monetary policy changes. In January 1993, for example, a sharp fall in the exchange rate caused the Reserve Bank to want monetary conditions to tighten, which it signalled by reducing the cash target to zero (returning to $20 million over the next four weeks). Following that episode, the bank found it did not have to intervene directly to change monetary conditions, but could signal its requirements to the market via official announcements to market participants with the implicit threat that the cash target would be changed if its requirements were not met. 5 Financial innovation continued to reduce the demand for settlement balances, however, and in August 1995 the daily cash target was reduced from $20 million to $5 million, where it remained for the next two years. Such a low daily cash target ($5 million compared with a broad money supply total of $70 billion) provided very little room to manoeuvre for signalling monetary policy changes. In March 1997, the bank adopted a new policy instrument called the Monetary Conditions Indicator (MCI), which was a weighted average of the ninety-day interest rate and the spot trade-weighted exchange rate. The weights were based on an empirical estimation that a 100 basis point fall in ninety-day interest rates had approximately the same impact on spending pressures over the medium term as a 2 per cent depreciation in the trade-weighted exchange rate (RBNZ, 1997: p. 13). Quarterly policy statements by the Reserve Bank after March 1997 contained desired projected values for the MCI, but in every case actual values turned out to be considerably lower than their pre-announced intentions. This undermined the effectiveness of the desired MCI as a signalling device, and in March 1999 the MCI was supplanted by an official cash rate (OCR) system, bringing the Reserve Bank of New Zealand into line with the world’s major central banks. Under this system, the bank announces its OCR approximately every six weeks. The bank then pays an interest rate 0.25 percentage points below the OCR for money deposited in its settlement accounts, and provides overnight cash at 0.25 percentage points above the OCR. This policy framework sets the floor and ceiling for the base interest rate of the domestic banking system, since no registered institution will accept a lower rate or pay a higher rate for overnight funds than is available by going to the Reserve Bank.

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A notable change in New Zealand, therefore, has been the shift from quantity targets (primary liquidity or settlement cash) to interest rate targets (the MCI or the official cash rate). This is generally held to be a minor change by economists brought up in the exogenous money supply tradition, following Poole’s (1970) famous IS–LM analysis, which showed that either quantity or interest rate targets can be used to implement monetary policy, although with different stabilisation properties depending on the nature of real and nominal shocks experienced by the economy. In that model, the LM schedule shows the combinations of real income and the interest rate at which the money market is in equilibrium. If the central bank wants to relax monetary conditions, it can do this by increasing the money supply. This shifts the LM schedule downwards since the rate of interest must fall to stimulate money demand. A lower interest rate leads to greater investment, which has a multiplied impact on real income (a movement along the IS schedule). Higher real income stimulates money demand, moderating the fall in the interest rate that would otherwise be required to maintain money market equilibrium. Given this analysis, the same effects could have been produced by setting a suitably lower interest rate target in the first place – which would have increased investment expenditure and real income as before – and allowing the money supply to increase by as much as is needed to accommodate the resulting increase in money demand. The change from quantity targets to interest rate targets, however, should be recognised as a very significant shift in theoretical framework. The original focus on quantity targets was based on what may be called the monetarist version of the quantity theory of money. 6 That theory argues that the monetary authorities determine the nominal money supply while economic agents in the aggregate determine real money demand. The price level then adjusts to a level where the nominal money supply is willingly held, so that there is a direct link between the quantity of money and the price level. In contrast, the IS–LM model holds that money market equilibrium is maintained by changes in the interest rate (not the price level). The change in the interest rate affects aggregate expenditure, and this aggregate demand interacting with the economy’s supply-side capacity then determines movements in the average price level. Within this theoretical framework, the responsibility of monetary policy is to use interest rate changes in order to keep aggregate demand close to aggregate supply, as explained in the following official briefing by the Reserve Bank of New Zealand: Where inflation expectations are well anchored, so that inflation is not a persistent, self-sustaining phenomenon, the primary driver of inflation (or deflation) is fluctuations in the level of overall demand relative to the economy’s capacity to meet that demand sustainably. Long-run supply capacity is determined by the real factors [discussed earlier in the briefing] such as labour, capital and productivity growth. If actual demand exceeds, or falls short of, that supply capacity, inflation pressures rise or fall. ... Demand is subject to cyclical influences from external events, government policies and the like. The task of monetary policy is to dampen rather than amplify the demand cycle, and thereby dampen rather

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than amplify the gap between supply and demand. It is this ‘output gap’ that lies behind inflation and deflation pressures. (RBNZ, 1999: p. 20) A ‘comparative statics’ analysis of the theoretical model underlying this approach is shown in Figure 10.2. The top diagram shows aggregate supply and aggregate demand, in which planned aggregate supply, AS0, is assumed to be a positive function of the actual price level, P. It would be a simple matter to incorporate different theories of why this might be so (expectations errors, for example, or

Figure 10.2 The IS–LM AS–AD theoretical framework for monetary policy

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fixed nominal wage contracts) or to incorporate the textbook Keynesian assumption of a horizontal aggregate supply curve up to some level of output representing bottleneck or capacity constraints. Planned aggregate demand, AD0, is assumed to be a negative function of the actual price level, perhaps because of its impact on nominal wealth. The initial point of equilibrium defines the prevailing price level, P0, and current level of real gross domestic product, Y0. If policymakers are targeting strict price stability, then their task is to choose a target interest rate, îb, which ensures that planned expenditure equals Y0 (that is to hold aggregate demand at the level which maintains P = P0). This is shown in the bottom diagram of Figure 10.2, containing the IS schedule. 7 There is an irony in all of this that is not widely recognised. The adoption of inflation targets by central banks is generally considered to reflect monetarism’s triumph over Keynesianism. Yet, central banks find that they are not implementing the monetarist school’s money market theory of the price level, but are instead using a goods market model that might be called ‘Chapter 21 Keynesianism’ after the chapter on ‘The theory of prices’ in The General Theory. In that chapter, Keynes observed that ‘the primary effect of a change in the quantity of money on the quantity of effective demand is through its influence on the rate of interest’ (1936: p. 298), and then argued that changes in effective demand would feed into higher prices depending on various supply-side elasticities and on how close the economy is to full employment. This theory has become the basis of modern monetary policy. This state of affairs raises some important questions for monetary policy. If aggregate demand is the main transmission mechanism, why do policymakers rely on monetary policy to stabilise planned expenditure rather than (for example) fiscal policy, especially counter-cyclical changes in government expenditure? Given that the way in which monetary policy affects aggregate demand is typically thought to be through the impact of interest rate changes on investment, how can the theory assume that monetary policy has no long-run impact on capacity growth (which depends in large measure on physical capital accumulation)? If monetary policy does affect capital accumulation, are there other policies that could be implemented to mitigate the need to rely on high interest rates to maintain price stability in times of inflationary pressure? The framework created in Chapters 7 and 8 of this book – based on Keynes’s (1937c, d) theory of finance – is able to address all of these critical issues. Controlling inflation through monetary restraint The distinguishing characteristic of the model developed in Chapters 7 and 8 compared with the IS–LM AS–AD model in Figure 10.2 is that it is a money market model rather than a goods market model. Its approach to the money market, however, differs from most previous models by the way in which it focuses on the supply and demand of credit-money created by the banking system. The model is therefore constructed on two fundamental optimising decisions: the portfolio allocation decisions of wealth holders between liquid bank deposits and illiquid

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equities; and the long-term funding decisions of capital managers between bank advances and shareholders funds. Using a simple constant returns to scale Cobb– Douglas utility function, the first decision produces a demand for bank deposits that is proportional to the nominal value of wealth, with the resulting ratio being called the money–wealth ratio, denoted h. That is, the optimising demand by households for credit-money balances, H*, is given from Equation 7.6 as: H* = hPK

(10.1)

For firms, the focus is on the long-term funding decision of new capital stock created by the previous period’s investment expenditure. The marginal debt– capital ratio, d, is defined to be the proportion funded by new bank advances (A, which must be matched by increased bank deposits, D). From Equation 7.1, this definition can be written as: 8 ΔD= ΔA = dP-1I-1

(10.2)

Differentiating Equation 10.1 and setting it equal to Equation 10.2 produces this book’s core equation for inflation, p, where g is the economy’s supply-side capacity growth rate (from Equation 7.13): p = [(d - h)/h]g

(10.3)

In Chapter 8, firms were assumed to be identical and perfectly competitive, and to make their funding decisions taking into account their interest liability on bank advances and the resulting impact on future inflation. Equation 8.5 records the model’s assumption that the rate of interest on bank advances, ia, increases above the financial system’s base interest rate, ib, more than proportionately as their marginal debt–capital ratio rises: ia = ib + i(d)

(10.4)

Equation 8.7 then shows that firms maximise their returns to shareholders by choosing the value for the marginal debt–capital ratio at which the marginal impact on the nominal interest rate just equals the marginal impact on the expected rate of inflation. Given Equations 10.3 and 10.4, this produces the following condition (see Equation 8.9): g/h = ∂i(d*)/∂d

(10.5)

In a perfectly competitive equilibrium, firms will undertake investment expenditure until the marginal efficiency of capital, e(g), equals the real interest rate, ia - pe. Again using Equations 10.3 and 10.4, this produces the following condition (from Equation 8.11):

Monetary policy and price stability e(g*) = {ib + i(d)} - {[(d - h)/h]g*}

117 (10.6)

These two conditions simultaneously define the economy’s equilibrium growth rate, g°, and the optimal marginal debt–capital ratio, d°, at that growth rate. This is shown in Figure 10.3, where without loss of generality it is assumed that d° is greater than the money–wealth ratio, h, and there is positive economic growth. From Equation 10.3, this implies that in equilibrium the economy is experiencing inflation, which it is the responsibility of the central bank to eliminate. Suppose the central bank increases the financial system’s base interest rate, ib. From Equation 10.4 this increases the nominal rate of interest on bank advances for any level of the marginal debt–capital ratio, and so increases the real interest rate in the equilibrium condition (Equation 10.6). To restore equilibrium, the marginal efficiency of capital must increase, which implies that the level of the capital stock – and hence the growth rate, given its beginning-of-period value – must fall. Thus the locus g*(d; h, ib) shifts to the left for all values of d, as shown in Figure 10.3. Starting at point A, the falling equilibrium growth rate reduces the impact of changes in the marginal debt–capital ratio on expected inflation, represented by the movement along the d*(g; h) curve to point B. At this new equilibrium position, both the growth rate and the marginal debt–capital ratio have declined on their values at A, and hence the inflation rate has also been reduced (Equation 10.3). By a suitable choice of ib’, the central bank is able to achieve d° = h at point B, and so can produce price stability, although at the expense of a lower growth rate than had been the case at point A.

Figure 10.3 Price stability through monetary restraint

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There is a standard result in the post-Keynesian literature which argues that monetary policy targeted to price stability is inefficient because it produces an unnecessarily low growth rate and high unemployment rate. That result is typically offered within a theory in which high unemployment is needed to restrain nominal or real wage demands and low growth is needed to restrict the mark-up of firms’ prices on their unit costs (see, for example, Dalziel, 1990). Figure 10.3 has produced a similar policy result, but in an entirely new context. In this case, low economic growth is required because the central bank can reduce monetary growth only by influencing the incentives driving private sector money creation. Under current institutional arrangements, this involves forcing up real interest rates and therefore slowing supply-side economic growth. Further, in contrast to more optimistic natural rate theories, the monetary restraint and associated slowdown in capacity growth must be permanent, since the theory predicts that if nothing else changes an economic recovery would lead to a resurgence in inflationary pressures as a result of a higher growth rate increasing the marginal benefit to firms of a higher marginal debt–capital ratio. In the model of Figure 10.3, this gloomy trade-off between price stability and economic growth is the result of policymakers being able to influence only the g*(d; h, ib) locus while the d*(g; h) locus stays constant. It is possible, however, that a tighter monetary policy might also shift the latter locus by affecting the responsiveness of interest rates to changes in the marginal debt–capital ratio. A higher policy-induced interest rate, for example, might make investment projects more risky on average (because of the higher interest demands on cash flows), encouraging banks to become more cautious as marginal debt–capital ratios rise. This greater caution could be reflected in larger increase in nominal interest rates being demanded as d rises. Under these circumstances, the impact would be felt in the optimising condition of Equation 10.5, since for any given growth rate, the marginal increase in inflation would equal the marginal increase in the nominal interest rate at a lower value of d. Thus, as well as the shift to the left of g*(d; h, ib) in Figure 10.3, there would also be a shift downwards of the d*(g; h) locus (which of course affects the shape and position of g*(d; h, ib), as discussed in the presentation of Figure 8.2). The outcome is illustrated in Figure 10.4. Compared with the result when there is no impact on interest rate sensitivity (point B in Figure 10.4, which is the same position as point B in Figure 10.3), the price stability equilibrium at point C involves a higher growth rate, g”, compared with g’. The economic intuition behind Figures 10.3 and 10.4 is particularly important, since it provides a potentially important implication for future policy development. The primary factor driving inflation in the model of this study is the net gain that managers of the capital stock are able to achieve under certain circumstances by adopting a value for the marginal debt–capital ratio that is above the desired money–wealth ratio of savers. Under these circumstances, monetary policy targeted at price stability must either reduce the marginal benefit or increase the marginal cost of an increase in this decision variable. One option that is always available is to reduce the marginal benefit of inflation by slowing economic growth through a higher real interest rate. This is the situation depicted in Figure 10.3. In Figure

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Figure 10.4 Price stability with interest rate responsiveness effects

10.4, however, an additional mechanism is incorporated, in which the marginality conditions are affected directly without any adverse impact on growth (in this case, by making the interest rate on bank advances more sensitive to changes in the marginal debt–capital ratio). These two mechanisms have been assumed in this section to occur as the result of a change in a single policy instrument (the base interest rate), but this raises the possibility that if a second instrument could be found that also impacted on the marginality conditions without affecting growth, this might allow policymakers to target price stability independently of the economic growth rate. This possibility is explored further in the following section. The optimal policy mix and cautious expansionism The previous section has demonstrated that central banks are able to achieve price stability through monetary restraint, and that the adverse impact this has on economic growth depends on the extent to which increases in the base interest rate directly affect the optimality condition in Equation 10.5 (that is the marginal net gain of changing d), rather than indirectly through the impact on the equilibrium condition in Equation 10.6 (that is the level of the real rate of interest). This suggests that if supplementary policies are available that affect the marginal net gain condition without impacting on the equilibrium condition, then it would be possible to design an optimal policy mix that could achieve both price stability (d = h) and some target growth rate compatible with supply-side constraints in the capital goods industry (g = g, where g is the target growth rate).

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From Equation 10.5, exploration of policy options along these lines must look for policies that either reduce the marginal benefit to firms of inflation or increase the marginal cost to firms of an increase in their marginal debt–capital ratio. An example of a policy of the former type is a variable capital gains tax on increases in the nominal value of capital assets. Note that such a capital gains tax rate would not have to equal one to eliminate all incentives to create inflation, since the benefit from inflation is received only on the value of capital financed by loans, whereas the extra cost would be incurred on all assets. An example of a policy that could affect marginal costs would be the adoption of selective controls designed to limit credit-financed speculation, as has often been advocated in the endogenous money literature. 9 In the context of this model, this policy proposal is equivalent to institutional reforms that caused the interest rate to rise sharply (to infinity in an extreme case where it becomes impossible to borrow funds past a certain portion of assets) once the marginal debt–capital ratio rises above the money–wealth ratio of the economy. It is not the intention of this study to consider the institutional details of these types of policy responses, nor to compare their possible benefits in controlling inflation generated by endogenously created monetary growth with their possible costs in terms of efficiency, equity and other economic criteria. Instead, the diagram in Figure 10.5 shows how the design of a supplementary policy that reduced the marginal net benefit received by shareholders from credit-driven inflation could allow policymakers to achieve target rates of inflation and growth simultaneously. To keep the discussion concrete, the diagram uses by way of an example changes in the value of a capital gains tax rate, denoted tp (where tp , > tp). Assume that the economy starts at point A, where inflation is positive (since d° > h) and growth is considered too low (since g° < g). If monetary policy is used alone in an attempt to achieve price stability (and only the real interest effect in Figure 10.3 applies), this would involve moving the economy along the d*(g; tp) curve to point B, producing a further departure from the growth target. If, on the other hand, monetary policy is used alone in an attempt to achieve faster growth, this would involve moving the economy along the d*(g; tp) curve to point C, increasing the rate of inflation. Suppose, however, that policymakers are also able to adjust the marginality instruments exemplified by the capital gains tax, tp. Then an optimal policy mix could be designed in which the base interest rate targets economic growth (so that the base interest rate is lowered from ib to ib’, at which rate the real rate of interest with no inflation achieves the level of investment needed to produce the desired growth rate, g) and the capital gains tax is used to target price stability (so that the capital gains tax is increased from tp to tp’, at which rate the maximising marginal debt–capital ratio is the non-inflationary value d = h). If the values of ib’ and tp’ are chosen correctly, the economy moves to point D, where there is no inflation and growth is at its target rate, g. Although the model that has allowed Figure 10.5 to be drawn is in many ways quite specific, the economic intuition underlying its major results is very general. Expressed in its broadest terms, the argument of this chapter has been as follows. Inflation generated by endogenous private sector money creation occurs when

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firms maximise the return to shareholders at a marginal debt–capital ratio that is greater than the money–wealth ratio of the economy. The actual marginal debt– capital ratio chosen is at a point where the marginal benefit of an increase in the ratio equals the marginal cost. The former depends, in part, on the growth rate of the economy, so monetary policy is always able to reduce inflation by reducing growth. There may be other supplementary policies, however, that affect marginal benefit or marginal cost without impacting on economic growth. If these policies are implemented, it should allow policymakers to accept a lower real interest rate, and hence a higher growth rate, without igniting a resurgence in inflation fuelled by faster endogenous money creation. This analysis also lends support to an approach to monetary policy that Stiglitz (1997) has termed ‘cautious expansionism’. 10 Suppose that a central bank is starting out at a point where prices are stable, but price stability is being maintained at a real interest rate that is considered too high given the supply-side capacity of the economy to grow. Within the framework of Figure 10.5, the central bank might seek to encourage growth (expansionism) by reducing its base interest rate, while at the same time announcing a strict commitment to raising interest rates again if inflationary pressures should emerge (cautious expansionism). The proviso means that the marginal gain condition in Equation 10.5 might be maintained at this lower base interest rate, since the central bank would be signalling to potential capital gains speculators that any rise in expected inflation as a result of their borrowing to purchase real assets would be immediately matched by an increase in nominal interest rates. To be effective, of course, such a promise would have to

Figure 10.5 The optimal policy mix

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be ‘credible’, but this strategy could then produce the required condition δia/ δd=δpe/δd at d = h with a lower base interest rate and higher real growth rate than would be required in a less credible policy regime or under a policy framework in which no attention was paid to the growth objective. 11 Eichbaum (1999b) has argued that adopting this cautiously expansionist monetary stance is one of the reasons why Australia (and the United States) achieved a higher average growth rate in the 1990s than did New Zealand with its more rigid focus on the single objective of price stability. Equity prices and consumer prices The previous sections have shown that base interest rate control can be inefficient if the central bank is unable to affect the optimality condition in Equation 10.5 directly but must instead choose the unique point on some given d*(g; h) locus that is consistent with price stability. In particular, from Equation 10.6 the real rate of return on capital in equilibrium is given by the following equation (where ib’ is the base interest rate required to produce d = h): e(g*) = ib’ + i(h)

(10.7)

If the base interest rate is the only instrument available to the central bank, its value in Equation 10.7 is higher as the inflationary pressure in any particular episode is higher, producing a higher real interest rate. This, of course, is the primary transmission mechanism by which a simple reliance on monetary policy maintains price stability in the model of this study. First, investment expenditure falls, which reduces the amount of new debt borrowed by firms and so slows the growth rate in the stock of credit-money. This reduces inflationary pressures directly. Second, the lower growth rate also reduces the benefit to shareholders of an increase in the marginal debt–capital ratio. The marginal cost of a higher d remains constant – since an increase in ib does not affect the function i(d) in the model – and so this also leads firms to reduce d. Overall, therefore, the price stability condition d’ = h can be achieved, but with lower investment and growth unless supplementary policies such as those discussed in the previous section can be used to affect the incentive for credit-money creation directly. Equation 10.7 can also be used to describe how the theory of equity prices contained in the core Equation 10.3 can be related to consumer price inflation that is more typically the target of monetary policy. Let PC be the price of consumer goods, and let WC, θC , YC and KC be, respectively, the wage rate, average labour productivity, output and the capital stock in the consumption goods sector. The marginal efficiency of capital, e, is then defined by the following implicit equation: (1 - (WC/PC)/θC)PCYC = ePKC

(10.8)

Equation 10.7 gives the marginal efficiency of capital, e(g*), that prevails in a zero inflation environment as a result of the necessary degree of monetary restraint

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(ib’) and the operating costs of the banking system, i(h). Hence, for given real wages (WC/PC) and labour productivity (θC), Equation 10.8 shows that the longrun price of consumption goods, PC, necessary to produce the required real rate of return on capital is determined by the nominal price of capital, P. If the price of equities rises by 10 per cent, for example, Equation 10.8 shows that the required rate of return on capital can be achieved if nominal wages and prices of consumption goods also both rise by 10 per cent. It is a core hypothesis in the post-Keynesian literature that ‘at the heart of the inflationary process is the question of relative income distribution’ (Eichner and Kregel, 1975: p. 1308), which is typically observed in a wage–price inflationary spiral. The analysis of this book extends that analysis by suggesting that in some cases the impulse for such an inflationary episode might lie not in the labour or goods markets, but might come from the finance market. In such cases, the basic mechanism is the same – income distribution conflict – but the agents who are seeking to increase their wealth at the expense of others are shareholders versus deposit-holding savers. The final chapter of this book will come back to this insight as part of its discussion of directions for further research into money, credit and price stability.

11 Conclusion

The economics literature on money and monetary policy contains two distinct schools of thought that can be represented by metaphors taken from the writings of Milton Friedman and Maynard Keynes. In the former’s essay on the optimum quantity of money, Friedman (1969: p. 4) supposed that ‘one day a helicopter flies over [the] community and drops an additional $1,000 in bills from the sky’. This helicopter metaphor requires a commodity theory of money, in which the good acting as the medium of exchange is also the price numeraire (so that its own price is the weighted average of all other commodity prices in the economy). Introducing a banking system into this framework does not change the basic metaphor. Either banks are considered to be retail providers of a complementary money commodity based on their cash reserves (so that the central bank helicopter is treated as flying over banks, as suggested by Dow, 1995: p. 114, which then supply a multiplied amount of the generally accepted medium of exchange) or banks are considered to be providing a substitute commodity that reduces the demand for money but does not affect money’s unique role in determining the average price level (Fama, 1980: p. 54). In both cases, the central bank holds the initiative in determining the rate at which the money supply grows, and so has direct control over the rate of inflation. In contrast, Keynes’s Treatise on Money (1930: p. 26) offered a metaphor in which ‘the central bank is the conductor of the orchestra and sets the tempo’. In this orchestra metaphor, it is the banks (and their customers) that do the work and have the initiative in setting the quantity supplied of the economy’s medium of exchange. The central bank’s role is to implement policies that provide the right incentives for banks to expand their deposits at an appropriate rate. Credit-money produced by the banking system is not a commodity in this framework but is an ‘acknowledgement of debt’ (Keynes, 1930: p. 5); hence this second school of thought can be called a finance theory of money (following Gurley and Shaw, 1960). In this finance theory, there is no direct relationship between money and the price level – there cannot be, since money is not a commodity – but most models in this tradition hold that money has a strong and reliable influence on the price level by affecting the rate of growth in aggregate expenditure (primarily through interest rate changes) relative to the economy’s supply-side capacity growth rate. Chapter 10 has argued that this finance theory provides the basis for

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modern monetary practice, despite most of the theoretical papers justifying that practice remaining embedded within the commodity theory framework. This book is firmly within the finance school of thought. The only source of wealth in the book’s model is the economy’s physical capital stock – the land, buildings, transport, plant and machinery that are produced by investment expenditure and which then expand the economy’s productive capacity. The model assumes that shares of ownership in that capital stock can be held either in the form of equities or in the form of liquid bank deposits that are matched by bank advances to firms offering a proportion of their capital stock as collateral. The basic framework is summarised in the aggregate balance sheets for firms, banks and households depicted in Table 11.1, where arrows have been drawn to emphasise that the wealth of households is just the nominal value of the economy’s capital stock held directly as equities or indirectly through the banking system as creditmoney. Adopting Freeman and Huffman’s (1991: p. 646) useful phrase, creditmoney can therefore be thought of as ‘intermediated capital’. Or, as Irving Fisher put it eighty years earlier, ‘banking is a device for coining into dollars land, stoves and other wealth not generally exchangeable’ (1911: p. 41). 1 Anyone who owns (or is about to purchase) real physical capital, and who satisfies the banking system’s current credit conditions, can obtain medium of exchange by offering their capital as collateral for a bank loan. The direction of the arrows in Table 11.1 is important. The process analysis in Chapters 5 and 6 (particularly in Figure 6.1) shows that it is the funding decisions of firms (or, more generally, of wealth managers) between bank loans and equity issues that determines the stock of credit-money that must then be held by households (or, more generally, by savers) at any moment in time. Households, of course, have their own liquidity preferences, and so the funding decisions of firms may lead to a greater stock of credit-money than households are willing to hold in their portfolios. In the two-asset model of this book, any excess supply of money must be matched by an excess demand for equities, and this excess demand will cause equity prices to rise. All writers on this subject are agreed to this point of the analysis. As Howells (1995b; 1997) and Arestis and Howells (1996; 1999) have recently summarised, the standard finance analysis then continues as follows. 2 Assuming that future returns are held constant, an increase in the price of equities reduces their yield, which therefore reduces the interest rate spreads between equities and bank loans, and between equities and bank deposits. Everything else staying the same, this should encourage firms to reduce the proportion of their capital Table 11.1 Credit-money as ‘intermediated capital’

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funded by bank loans (since equity issues are now relatively cheaper), and should encourage households to increase their demand for credit-money (since equity returns are now relatively lower), until balance between supply and demand is restored. The point of departure in this book has been to query the italicised proviso that future returns are held constant. In a study of money and credit, such a proviso assumes the answer to what is to be explained; namely, how can price stability be maintained? In particular, suppose that after an increase in equity prices, workers and firms are able to increase wages and prices of consumption goods by exactly the same proportion. Following the analysis at the end of Chapter 10, let P be the price of capital goods (assumed to equal the price of equities), let PC be the price of consumer goods, and let WC, θC, YC and KC be the wage rate, average labour productivity, output and the capital stock in the consumption goods sector. The rate of return in the consumption goods industries is then defined by the sector’s total profits divided by the nominal value of its capital as follows:

(11.1)

Hence if WC and PC do rise in the same proportion as P, Equation 11.1 reveals there is no change in the rate of return on capital, and so there is no change in interest rate spreads. The standard equilibrating mechanism cannot operate under these circumstances; instead, an excess supply of credit-money produces inflation in both equity and consumer prices, and it is the increase in nominal wealth that leads households to demand the extra bank balances. This is the main theoretical insight arising out of this book. The main policy insight then comes from the model’s implications for understanding how central banks control inflation through interest rate policy by affecting the funding decisions of firms (as analysed in Chapter 10). The remainder of this final chapter is structured as follows. The next section provides a brief non-mathematical summary of the book’s model and its major policy conclusions in a series of numbered bullet points. There are then two sections that discuss important examples where an increase in equity prices may not lead to an increase in consumer prices despite the rate of return on capital remaining unchanged. In the first example, the increase in equity prices does not immediately cause an increase in the price of capital goods (so that Tobin’s qstatistic assumes a value greater than unity), giving rise to what would be experienced as a share market boom. In the second example, the increase in equity prices is compensated by a reduction in the real wage rate paid by firms, providing a new insight into the standard post-Keynesian analysis of inflation as the result of an underlying conflict over income shares. Finally, this book has adopted throughout the heuristic assumption of a closed economy. It turns out that there are some very important changes required when the model is extended to include international trade and international capital movements. The last section of this

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chapter discusses some of these changes, introducing what is perhaps the most important area for further research within the framework offered by this book. A précis of the model and policy implications Despite the use of the generally unfamiliar technique of process analysis, and despite some of the more mathematical and graphical analyses in Chapters 8 and 10, the model of this book is not complicated but is based on a few simple principles that give rise to important policy conclusions. The purpose of this section is to summarise in logical order the economic intuition of those key principles and policy conclusions. This is done in a series of sixteen short bullet points. 1

2

3

4

5

6 7

8

The starting point of the analysis is the level of (net) investment expenditure that takes place during a given interval of time. This expenditure creates new capital stock, which increases the economy’s supply-side capacity and so defines the economy’s trend growth rate (assuming a constant capital-output ratio). The investment expenditure must be financed, which is made possible by the ability of the banking system to provide bank loans using the new capital stock as collateral. These bank loans become bank deposits which are the predominant medium of exchange (credit-money) in modern economies. Investment expenditure financed by endogenous credit-money creation triggers an income–expenditure multiplier process until the initial value of investment is matched by an equal value of voluntary saving by income earners. Thus, investment gives rise to saving, and not vice versa. Given the new capital stock and new savings created by the investment expenditure, firms must decide how to fund their new assets in the long-term using some combination of bank loans and equities, and households must decide how to allocate their new wealth between equities and bank deposits. The decision of households depends on liquidity preferences. In this book, a very simple liquidity preference model is used, in which the resulting demand for credit-money as a stock is shown to be proportional to the nominal value of wealth (that is the nominal value of the total capital stock). The decision of firms depends on interest rates and the expected inflation rate. In this book, the proportion of the new capital stock that is funded by bank loans is termed the marginal debt–capital ratio. If the marginal debt–capital ratio of investing firms is greater than the money– wealth ratio of households, then this means the volume of credit-money supplied by the funding decision of firms is greater than the volume voluntarily held to satisfy the liquidity preferences of households. The excess money balances are used by households in an attempt to increase their holdings of equities. The excess demand for equities causes the price of equities to rise at a rate given by the difference between the marginal debt–capital ratio and the money– wealth ratio, divided by the money–wealth ratio, multiplied by the economy’s

128

9

10

11

12 13

14

15

16

Conclusion

supply-side growth rate (Equation 7.13). This inflation restores balance in the household’s portfolio by increasing the nominal value of wealth until the supplied credit-money is willingly held. The inflation also produces a wealth transfer from bank depositors to bank creditors that is exactly analogous to the well-known inflation tax imposed on money holders in a standard commodity-money analysis. This transfer is offset by interest payments, so that the optimal marginal debt–capital ratio for shareholders occurs where the increase in expected inflation arising from a marginal increase in the ratio’s value equals the marginal increase in the nominal interest rate on bank advances. The equilibrium level of investment expenditure in a perfect competition model occurs where the expected real return on investment (the marginal efficiency of capital) equals the real interest rate defined as the nominal rate of interest on advances less the expected rate of inflation. Taken together, the previous points produce a model that defines equilibrium values for the (closed) economy’s money–wealth ratio, marginal debt–capital ratio, supply-side capacity growth rate, equity price inflation rate, real interest rate, nominal interest rate and marginal efficiency of capital. A central bank’s principal instrument of monetary policy is changes in the financial system’s base interest rate, which affects the interest rate charged on bank advances. A central bank can always use an increase in the base interest rate to reduce inflation, since this increases the economy’s real interest rate, reduces the equilibrium growth rate, and so reduces the marginal benefit of increases in the marginal debt–capital ratio. A lower growth rate and a lower marginal debt–capital ratio both reduce inflation. If an increase in the base interest rate also increases the sensitivity of nominal interest rates to increases in the marginal debt–capital ratio (by making investment projects more risky as debt–equity ratios rise), this increases the marginal cost of such increases, and so inflation control can be achieved at a higher growth rate than occurs if point 13 is the only mechanism in operation. This suggests that there may be other policies available, such as a capital gains tax or controls on credit for speculation, that can alter the marginal benefit or marginal cost of increases in the marginal debt–capital ratio without affecting the economy’s equilibrium growth rate. If there are alternative policies available, an optimal policy mix could be designed in which the real rate of interest is used to achieve a target rate of economic growth compatible with supply-side constraints, while the marginality conditions are used to achieve a target rate of inflation. The theory of this book focuses on inflation in equity prices. Given the model’s equilibrium required rate of return on capital, however, the price of consumption goods will rise at the same rate as the price of equities if Tobin’s q-statistic adopts its long-run value of unity, and if the real wage rate does not change (Equation 10.8).

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These sixteen points constitute a finance theory of money that provides a framework for further research aimed at better understanding the processes of inflation in order to create more efficient policy mechanisms for achieving price stability and high sustainable economic growth. The next two sections discuss some of the implications if each of the two provisos in the sixteenth point above are not satisfied. Tobin’s q-statistic3 Throughout this book it has been assumed that the price of an equity and the price of capital goods are identical, since both equities and physical capital are measured in the same units (see the discussion in Chapter 6). At least since the famous analysis of Tobin and Brainard (1968) and Tobin (1969), it has been recognised that stock market values can depart from the value of their underlying real assets for reasonably lengthy periods of time. This phenomenon is captured in Tobin’s qstatistic, which can be defined here as the ratio of equity prices to physical capital prices (assuming a common unit for quantities). Following the notation introduced in Chapter 6, let P continue to refer to the price of capital goods, and let Q denote the price of equities. Tobin’s q-statistic is then defined by: q = Q/P

(11.2)

Tobin’s q should equal unity in the long run but may rise above (or fall below) that value for some time, depending on different expectations in the marketplace and imperfections in the physical capital market. Chapter 6 has already shown that q > 1 does not affect the process analysis of Figure 6.1, but only affects the distribution of equities between existing and new shareholders. That analysis concluded with the observation that if Q > P, households are effectively deluding themselves about the true value of the capital stock backing their equities. This is likely to have an impact on their stock demand for money, which is easily incorporated into the model of Chapter 7. In particular, suppose that the stock demand for money is proportional to nominal wealth, defined now to equal the accumulated physical capital stock, K, valued at current equity prices, Q, rather that P. Equation 7.7 for the total demand for money (including the income demand for transactions balances) then becomes: MD = F + hQK = F + hqPK

(11.3)

Totally differentiate this equation to give the change in money demand (assuming h and q are constant): ΔMD = ΔF + hqP-1ΔK + hqΔPK-1

(11.4)

The change in money supply is still given by Equation 7.1, repeated here as Equation 11.5:

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ΔMS = ΔF + dP-1I-1

(11.5)

Setting Equation 11.4 equal to Equation 11.5, eliminating the common term, and rearranging the result produces the following expression for inflation in the price of equities: p = [(d - hq)/hq]g

(11.6)

Equation 11.6 can be compared to the key analytical result in Equation 7.13 (see also Equation 16 in Dalziel, 2000). The only change is the presence of Tobin’s qstatistic in order to recognise the impact of the share market boom on households’ perceived nominal wealth. Note also that when q adopts its long-run value of unity, Equation 11.6 simplifies back to the standard formula in Equation 7.13. The inclusion of Tobin’s q-statistic is not just a mathematical nicety – it has some important real world implications. Consider, for example, a scenario in which households increase their demand for equities. From a position of non-inflation equilibrium, such an event would be represented in the model by an exogenous shock to liquidity preferences producing a fall in the value of the parameter h in the utility function of Equation 7.2. 4 Everything else remaining the same, this produces an excess supply of credit-money, which is used to demand extra equities. The excess demand causes equity prices to rise. Suppose that the price of capital goods does not change (perhaps because firms expect the central bank to act in a way that will prevent them from raising the price of consumption goods to compensate for higher capital goods prices), so that p remains equal to zero in Equation 11.6. The result is an increase in Tobin’s q-statistic, which must rise by the same percentage as the fall in h in order to maintain d = hq (to satisfy p = 0 in Equation 11.6). The scenario described in the previous paragraph is an example of how a share market bubble can be created by a change in the liquidity preferences of households, perhaps fuelled by asset price speculation by a subset of households. The outcome q > 1 is not sustainable, of course, and this disequilibrium will be resolved in one of two ways. First, the central bank might choose to accommodate the equity price inflation, allowing the prices of consumption goods to rise in the same proportion. This would increase the net present value of capital in the same proportion (assuming wages also rise and the required rate of return on capital does not change), so that Q = P again. Alternatively, the central bank might increase its base interest rate in order to offset the inflationary pressures. Once this is fed through into higher rates of interest on bank advances, firms would be given an incentive to change their funding policy towards greater equity issues, and the extra supply of equities would reduce Q back towards P. 5 Note that the higher real interest rate implied by this alternative would also slow real capacity growth in the economy, illustrating the classic dilemma facing central banks concerned about maintaining price stability as well as promoting high sustainable growth.

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Equity prices and real wages One of the fundamental building blocks in post-Keynesian economics is the proposition that inflation is a result of conflict over real income shares. In mathematical models of this proposition, it is generally assumed that firms have a target mark-up on unit costs while workers have a target real wage rate. To the extent that the nominal aggregate income implied by these targets exceeds real output valued at current prices, inflation is generated to reduce the real share of those in the economy who lack market power (see, for example, the analysis and references in Dalziel, 1990). The model of this book is able to introduce a new element into that theory by highlighting the income distribution conflict between the owners of capital (shareholders) and the owners of labour (workers) in the transmission channel from capital goods prices to consumer goods prices. Consider Equation 10.8 repeated here as Equation 11.7. It shows aggregate profits for the consumption goods sector on the left-hand side, which must equal the sector’s return on the nominal value of its capital stock on the right-hand side. P is the price of capital goods, PC is the price of consumer goods, and WC, θC, YC and KC are the wage rate, average labour productivity, output and the capital stock in the consumption goods sector. (1 - (WC/PC)/θC)PCYC = ePKC

(11.7)

Suppose that there is an increase in the nominal price of capital, P (the impact of which might be amplified on the right-hand side of Equation 11.7 if the central bank also increases the real rate of interest to offset the resulting inflationary pressure). Equation 11.7 shows that this need not feed through into a higher price for consumption goods, PC, if the real wage (WC/PC) falls, at least relative to average labour productivity, θC. There is therefore a conflict between shareholders and workers that can be further clarified with a little algebraic manipulation. Let the output capital ratio in the consumption goods sector be denoted by βC = YC/KC. Then, dividing both sides of Equation 11.7 by PCYC and rearranging the result produces the following sum:

(11.8)

This equation records that the real wage received by workers (WC/PC) weighted by the inverse of labour’s average productivity, and the real price of equities (P/ PC) weighted by the ratio of the real rate of return on capital to the output capital ratio, must sum to unity. If the workers’ real wage target and the capitalists’ real equity price target are incompatible with this condition, the implied income distribution conflict will lead to consumer price inflation unless suppressed by central bank action.

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The small open economy model This final section is concerned with the special characteristics of small open economies. The analysis in this book has been concerned solely with a closed economy, but there are important issues to consider when an economy is opened to international trade and to international capital movements. Interest rate increases, for example, are likely to attract capital inflows that will cause the exchange rate to appreciate. A higher exchange rate may reduce the domestic price of imported goods, affecting the consumers price index measure of inflation. These exchange rate effects open up a secondary transmission mechanism for monetary policy, but they may also reduce the ability of the monetary authorities to raise domestic interest rates above the prevailing world rate, which would make it difficult for certain types of inflationary pressure to be offset by monetary policy. This section concludes with a recent example from New Zealand, where this appears to have been an important consideration. The impact of monetary policy on the exchange rate and the balance of payments current account can be shown in a simple supply and demand model of the foreign exchange market (see Figure 11.1). The horizontal axis depicts the quantity of the domestic currency that is bought and sold in the foreign exchange market, which for simplicity will be measured in sterling (£). The vertical axis depicts the international price of the domestic currency in the foreign exchange market, which will be denoted as ε. Consider the current account first. Supply of domestic currency comes from agents wishing to make current account payments overseas, particularly importers. Higher exchange rates make importing more profitable (everything else staying the same), and so the supply schedule is shown as an upward-sloping curve, labelled SCA. Demand for domestic currency comes from

Figure 11.1 The foreign exchange market

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agents receiving current account payments from overseas, particularly exporters. Higher exchange rates make exporting less profitable (everything else staying the same), and so the demand schedule is shown as a downward-sloping curve, labelled DCA. Now consider the capital account. Without loss of generality, assume that the economy is experiencing a balance of payments current account deficit, which implies a positive net capital inflow from overseas. As overseas residents make loans to domestic residents or purchase domestic assets, they must convert their own currencies into the domestic currency. Hence the net capital inflow (denoted NCI) is an additional source of demand in the foreign exchange market, and so total demand is given by the horizontal sum of DCA and NCI. The point at which this total demand curve intersects the supply curve defines the exchange rate’s equilibrium value, denoted ε°. By construction, point A (at which ε° intersects DCA) defines current account receipts, and point B (at which ε° intersects SCA) defines current account payments, and so the horizontal distance AB represents the current account deficit (denoted CAD in the Figure 11.1) as well as the net capital inflow that finances the deficit. Suppose now that the economy experiences signs of rising inflationary pressure, which leads to a policy-induced increase in the base interest rate. Chapter 10 has shown that in a closed economy this results in a rise in the real interest rate, but in an open economy with unrestricted international capital flows, such an increase in the domestic real interest rate will attract a larger capital inflow. This is represented in Figure 11.2 by a shift to the right of the total demand curve, DCA + NCI′, whereas the demand from current account receipts, DCA, and the supply for current account payments, SCA, remain unchanged. The diagram shows that this causes the equilibrium exchange rate to rise from ε° to ε′ crowding out some current account

Figure 11.2 The foreign exchange market with a higher domestic interest rate

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receipts (including exports) and encouraging further current account payments (including imports). The current account deficit widens. This exchange rate effect of monetary policy explains why the central banks of some countries (in Canada and New Zealand, for example) have sought to construct a monetary conditions index that incorporates movements in both the domestic interest and the foreign exchange rate. 6 Within the standard finance theory in which monetary policy operates through changes in aggregate demand, it is important to be able to estimate the different impact of interest rate movements and foreign exchange movements on planned expenditure. This exchange rate mechanism also opens up additional distributional issues in monetary policy, since a higher interest rate is more likely to affect investment expenditure and household spending on consumer durables, whereas a higher exchange rate is more likely to affect exporters and domestic manufacturers competing against imports. These differences can have important political repercussions, as will be illustrated with a recent New Zealand example shortly. In the context of this book’s model, there are two key observations to make. 7 First, a policy-induced increase in the exchange rate might be expected to reduce the domestic price of imported goods given fixed world prices. To the extent that imported goods appear in the weighted basket used to calculate the consumer’s price index, this effect may help the monetary authorities to achieve any given inflation target despite ongoing increases in the price of domestically produced consumption goods (Whitwell, 1987; 1990). Following on from the analysis of the previous two sections, this provides a potential third way in which equity prices may rise without an equivalent increase in the consumers price index. Second, and closely related to this first observation, monetary policy in a small open economy may find it more difficult to constrain domestic inflationary pressures if they are due to the causes analysed in this book. Recall from Equation 8.7 in Chapter 8 that the optimising value for the marginal debt–capital ratio is where its marginal impact on the expected inflation rate equals its marginal impact on the interest rate on bank advances: ∂ia/∂d = ∂pe/∂d

(11.9)

In Chapter 10, it was suggested that a credible commitment by the central bank to increase nominal interest rates whenever there are rising inflationary expectations could allow a policy of ‘cautious expansionism’ to reduce the real interest rate (to encourage economic growth) while maintaining control over credit expansion (to prevent inflation). In a small open economy with perfect capital mobility, however, monetary policy may have relatively little control over the domestic interest rate, as any departures from the world interest rate are likely to produce an immediate change in the net capital inflow, with a corresponding change in the exchange rate and balance of payments current account deficit. Under these circumstances, a tightening of monetary conditions may be transmitted entirely through the exchange rate rather than the rate of interest. To illustrate these points, consider New Zealand’s monetary experience in the

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Figure 11.3 New Zealand exchange and interest rates, January 1990 to December 1999. Source: Reserve Bank of New Zealand.

mid-1990s. Throughout 1995 and 1996, consumer price inflation threatened to rise, or did rise, slightly above the then target ceiling of 2 per cent per annum. It was widely agreed that this was largely due to sharp increases in housing costs in the largest city, Auckland. The Reserve Bank responded by progressively tightening monetary conditions. As Figure 11.3 shows, however, this had almost no impact on domestic interest rates (at least after December 1994), but instead produced a sharp appreciation in the exchange rate, which peaked in the first quarter of 1997 nearly 20 per cent higher than its value at the end of 1994. Consequently, there were widespread complaints within New Zealand that inflationary pressures caused by property speculators in Auckland were being addressed by monetary policy directed primarily at farmers and other exporters in the regions. This became an important election issue in the 1996 general election, and was one of the factors that led the new coalition government to raise the inflation target ceiling to 3 per cent as its first policy initiative (see Dalziel 1997b; 1998c, for further discussions of this episode and policy change). Nor is it difficult to think of other episodes around the world where policymakers have struggled to keep asset prices stable (either on the stock exchange or in real estate), even in the absence of any particularly strong inflation or deflation in the average price of consumption goods. Thus the model presented in this book has important practical applications for policy advisors trying to understand and respond to such episodes. More generally, the model’s integration of the finance theory of money into the multiplier theory of expenditure and income provides a solid analytical framework to address what are still ‘the outstanding faults of the economic society in which we live’; namely ‘its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes’ (Keynes, 1936: p. 372).

Appendix: Notation

A AD AS B c cu C CB Cp CAD d D D CA e E Ec ED En ES F g g G h H i ia ib îb id ig in I

bank advances aggregate demand aggregate supply the stock of public debt (government bonds) the marginal propensity to consume out of income the ratio of cash held by the public to bank deposits real consumption expenditure cash reserves held by the banking system cash held by the public balance of payments current account deficit the marginal debt–capital ratio bank deposits demand in the foreign exchange market from current account receipts the marginal efficiency of capital the stock of equities on issue implicit new issue of equities demand for equities explicit new issue of equities supply of equities finance for investment or fiscal deficit expenditure rate of growth in the economy’s supply-side capacity target sustainable growth rate real government expenditure on goods and services the money–wealth ratio aggregate nominal money balances (‘hoarding’) the nominal rate of interest the nominal rate of interest on bank advances the banking system’s base interest rate set by the central bank the central bank’s target base interest rate the nominal rate of interest on bank deposits the nominal rate of interest on public debt (government bonds) the ‘natural’ rate of interest investment expenditure

Notation IC j K KC l L1 L2 L m M MD MS n N NCI p pe P PC PG PC PY q Q re R s S Sc Sr SCA t tp T Tr un ut U WC Y YC z Z Z0

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indifference curve the proportion of investment expenditure undertaken in the private sector the accumulated capital stock capital stock in the consumption goods sector the proportion of nominal wealth held in liquid form transactions demand for liquidity precautionary demand for liquidity liquidity preference function the portion of the budget deficit that is monetarised the aggregate (broad) money supply the demand for credit-money the supply of credit-money the currency–wealth ratio the stock of currency (notes and coins) the net capital inflow the rate of inflation in capital goods prices the expected rate of inflation in capital goods prices the average price of capital goods the average price of consumption goods the average price of government expenditure goods Phillips curve nominal income Tobin’s q-statistic, the ratio of the price of real capital goods to the price of equities the average price of equities banks’ reserve ratio of cash reserves to bank deposits repayments to the revolving fund of investment finance marginal propensity to save out of income aggregate saving retained profits (‘corporate saving’) saving in round r of the multiplier process supply to the foreign exchange market for current account payments the current time period capital gains tax rate the terminal round in a multiplier process tax revenue net of transfer payments in round r of a multiplier process the ‘natural’ rate of unemployment the rate of unemployment in period t household utility function wage rate per worker in the consumption goods sector real aggregate income or output real output in the consumption goods sector the ratio of the budget deficit to investment expenditure the government’s total budget deficit the budget deficit excluding tax flows arising out of a subsequent multiplier process

138 βC ε θC k λ μ σ

Notation output-capital ratio in the consumption goods sector the exchange rate average worker productivity in the consumption goods sector the capital output ratio the Lagrangean multiplier in a constrained optimisation problem a critical realist mechanism from event x to event z the average rate of voluntary saving out of income

Notes

1 The quest for price stability 1

2

3 4 5

6 7

8

See, for example, the summaries in Holden et al. (1987), Zaida (1986) and Argy et al. (1989). Ireland was an exception choosing to introduce neither an explicit incomes policy nor monetary growth targets. The latter became unnecessary when Ireland joined the European Monetary System in 1989, whereas Kennedy et al. (1988: p. 77) regret the former decision in the following terms: ‘...while the strategy [in June 1977] recognised the need for pay restraint by setting a very low target for pay increases, no instruments were devised to achieve this target. Without such instruments, the stimulation of demand was likely to intensify wage pressures, and in the event the target for pay restraint was substantially breached.’ Monetary targeting was investigated by the Reserve Bank of New Zealand in the late 1970s and early 1980s, but was not adopted at any stage. The government did from time to time seek to persuade the financial sector to adopt voluntary credit growth guidelines, especially in 1978 and 1979, see, for example, Deane et al. (1983: Part 3). See Dalziel (1991) for a survey of the theoretical explanations suggested by different economic schools for this association between disinflation and unemployment. For a good summary and discussion of the major principles of inflation targeting, see Bernanke and Mishkin (1997). Note that some economists have argued that a small rate of positive inflation is beneficial for the economy on the basis that if wages or prices are sticky downwards, a low rate of inflation facilitates relative price changes in response to economic shocks. See, for example, Akerlof et al. (1996) and Sarel (1996). See, for example, Eckstein (1981), Bruno and Sachs (1985), Blanchard and Summers (1986) and Hicks (1989: Chapter 4) on the first model; and Cornwall (1984), Eichner (1986: pp. 113–150), Kregel (1989) and Arestis and Skott (1993) on the second. See, for example, Tobin (1980), Meade (1982), Blanchard and Summers (1987) and Weale et al. (1989) for discussions of the first proposal; and Layard (1986: Chapter 10), Rousseas (1986: Chapter 6), Wallich and Stockton (1989) and Harcourt (1992) for discussions of the second. See, for example, the recent exchange between Cottrell (1994a) and Moore (1994), as well as the commentary by Dalziel (1996a).

2 What is money? 1

This chapter is a slightly modified version of my paper ‘On the evolution of money and its implications for price stability’, which first appeared in the Journal of Economic

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5

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Notes Surveys, Vol. 14(4) (2000): pp. 373–93. I am grateful to the journal for permission to reproduce that material here, and to Kevin Dowd and Les Oxley for very helpful comments on the original article. This distinction between money proper and money substitutes was also an important doctrine of the banking School in British monetary debates of the nineteenth century; see, for example, Schwartz (1987: p. 184). As Dow (1995: p. 114) observes, this type of model does not replace the metaphor of cash being dropped by helicopter – a reference to Friedman’s (1969: pp. 4–7) famous analogy – but restricts the cash-carrying helicopters to flying over banks. Instead, the post-Keynesian school argues that ‘at the heart of the inflationary process is the question of relative income distribution’ (Eichner and Kregel, 1975: p. 1308). Thus, monetary policy is viewed as having an impact on inflation to the extent that it moderates income distribution conflict, especially by increasing unemployment to weaken the ability of workers to press for higher wages (see, for example, Dalziel, 1991: pp. 342–6). Goodhart (1992: p. 23) observes that ‘the maintenance of the convertibility of the domestic money stock into an external standard of value has been the normal procedure for all central banks (with the important exception of the U.S. Federal Reserve System) for the greater part of their history.’ Some have argued along these lines for a return to the gold standard in order to remove political mismanagement from monetary policy (Barro, 1979: p. 31; Weintraub, 1984; White, 1988). Others have argued that the gold standard did not remove the need for discretionary monetary policy in practice (Davutyan and Parke, 1995) or in theory (Cooper, 1982; Cagan, 1987), and have warned that there are significant real costs under a strict gold standard (Cooper, 1982; Bordo, 1984). Irving Fisher’s (1920) ‘compensated dollar’ plan should be mentioned in this context, since some modern authors have interpreted his plan as a form of indirect convertibility scheme in which the price of the medium of redemption is adjusted depending on the extent to which the price index departs from par (Dowd, 1995: p. 75; see also Bordo, 1984; Sumner, 1990). Note, however, Patinkin’s (1996) observation that Fisher based his proposal on the quantity theory hypothesis that a nation’s price level would reflect the amount of gold embodied in its coins. Although note Humphrey’s (1990) evidence that Henry Thornton and Thomas Joplin have prior claims. Wicksell considered only gold and banknotes to be proper money, but it is convenient to follow here Patinkin’s (1965: p. 303) interpretation of Wicksell’s model as a ‘pure inside money economy’. Others who have interpreted Wicksell in monetary terms include Rose (1969), Laidler (1972), Jonung (1979), Hadjimichalakis (1981), Kohn (1981), Hicks (1982), Fischer (1983) and Siegel (1984). Mention should be made of the ‘credit channel’ literature initiated by Bernanke(1983), which can be considered as following the Wicksellian tradition. Bernanke suggests that banks have a unique role in providing credit to small firms, and so monetary restraint slows aggregate expenditure by imposing a credit crunch on such firms. Gertler and Gilchrist (1994) provide a good overview and some supporting evidence for the United States.

3 Credit-money and inflation 1 There have been a number of good surveys of the theory of endogenous money published in recent years; see, for example, the articles by Arestis and Eichner (1988), Graziani (1990), Niggle (1991), Hewitson (1993; 1995), Cottrell (1994b) and Howells (1995a), the relevant chapters in Dow and Earl (1982), Rousseas (1986), Moore (1988c), Earl (1990), Wray (1990), Arestis (1992; 1993), Lavoie (1992), Dow (1993) and Deleplace and Nell (1996) and the empirical applications in Moore and Threadgold (1985), Gedeon

Notes

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5

6

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(1985–86), Myatt (1986), Arestis (1987–88), Arestis and Driver (1988), Moore (1989c), Wray (1990), Marselli (1993) and Hewitson (1997). 2 Within a free banking context, for example, Selgin (1988: pp. 40–2) calls this the ‘principle of adverse clearings’. Arestis and Howells (1996: pp. 541–3) make the important point that this argument does not deny the money multiplier model as a theoretical construct, but rather hypothesises that the monetary authority’s policy reaction function causes it to behave in a particular way. Along similar lines Wray (1992a: p. 300) argues that the money supply is not ‘exogenously controllable’. This debate was launched in recent times by Basil Moore’s very influential (1988c) book, although Kaldor (1980; 1982) and Kaldor and Trevithick (1981) are important earlier publications. Subsequent contributions to the debate include Arestis and Howells (1996), Davidson (1989), Deriet and Seccareccia (1996), Dow (1996a), Goodhart (1989; 1991), Heise (1992), Lavoie (1996), Moore (1989b; 1991a; 1991b), Niggle (1991), Palley (1991; 1994; 1996), Pollin (1991), Rousseas (1989) and Wray (1992a; 1992b; 1995). See, for example, Godley and Cripps (1983: Chapter 5), Lavoie (1984), Arestis (1987– 88), Palley (1987–88), Dow and Saville (1988), Moore (1988a), Messori (1991) and Wray (1991b). Arestis and Howells (1999: p. 117) observe that ‘firms have not been the main source of loan demand in the UK for several years’ and that ‘since the early 1970s, households’ outstanding debt to banks and building societies has exceeded the combined debt of industrial and commercial corporations and (non-bank) financial institutions’. The implications of this for endogenous money theory have not been well explored to date. This claim was strongly contested by Goodhart (1989; 1991) and Wray (1991a) when it first appeared, and again more recently by Howells (1995b; 1997) and Arestis and Howells (1996; 1999). None of these criticisms makes the distinction adopted here between consumption and investment goods production. Chapter 7 of this book will confirm that ‘convenience lending’ does account for some of money balances created to finance investment expenditure, but it will also show that it does not ensure that a position of excess supply never exists when there is production of investment goods. See, for example, Kalecki (1935a, b), Keynes (1937c, d), Davidson (1972: pp. 270–2), Minsky (1976: pp. 133–6), Sawyer (1985: pp. 93–4), Wray (1989) and Dalziel (1996a, c). Note also that if expectations are not realised in the consumption goods sector, firms may build up unintended inventories. As Foster (1987; 1990) points out, such an increase in inventory stocks is treated by national income accountants as ‘investment’, further justifying the focus of endogenous money theorists on this category. It seems more natural to talk about an excess supply of credit-money, since in a growing economy, the money supply will grow endogenously in response to the steadily increasing demand for credit (Minsky, 1963: p. 6; Forman et al., 1985; Moore, 1989a). Notice however that if the credit is being used to finance economic expansion, this would tend to increase the demand for transactions money balances (Cottrell, 1986; 1994a), and so the possibility of an excess demand for credit-money cannot be ruled out. This last point may not be obvious. If prices and wages rise at the same rate, then so does the nominal value of profits. The rate of return on capital in a given year is given by the nominal profits divided by the nominal value of capital, and so if prices and wages rise at the same inflation rate as the price of capital goods, there is no change in the rate of return. This point is discussed in more detail in Chapter 10 on monetary policy.

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4 Critical realism and process analysis 1 This is in sharp contrast to the classical proposition that all investment must be preceded by either voluntary or forced saving. Commentators who emphasise this aspect of The General Theory include Hicks (1936: p. 239), Robinson (1937: Chapter 2), Meade (1975: p. 82), Patinkin (1976: p. 65; 1993: p. 647), Bridel (1987; Chapter 9), Clarke (1988: p. 270), Skidelsky (1992: p. 554) and Trevithick (1994: p. 77). Hayek (1932) was a contemporary of Keynes who argued strongly for the forced saving doctrine, and more recently Ahiakpor (1990; 1995) has accused Keynes’s theory of being based on a fundamental misunderstanding of key concepts in the classical model (Dalziel, 1998a, presents a contrary view). Other modern authors who have advocated the use of process analysis include Chick (1977: Chapter 8; 1983: Chapter 14, 1997), Cottrell (1986), Davidson (1994: pp. 41–2), Loasby (1989: Chapter 11) and Pollin (1997: pp. 317–9). 2 This section is based on a seminar presented to the Realism and Economics workshop series, Kings College, Cambridge, 2 May 1994. I am particularly grateful to Tony Lawson for his invitation to participate in that series, and for his helpful comments on an earlier draft. 3 See also Robinson’s 1974 essay and Kaldor’s 1985 lectures. 4 Sheila Dow (1990a; 1996b; 1997; 1999) has been particularly forceful in warning economists against such ‘either-or’ approaches, which she labels ‘dualism’. 5 The Cambridge Circus is ‘the name retrospectively given to a group of Keynes’s younger colleagues who started meeting after the Treatise was published in October 1930: Richard Kahn, Piero Sraffa, Austin Robinson, Joan Robinson and James Meade’ (Skidelsky, 1992: p. 447). 6 It perhaps needs to be emphasised that each round is not identical to a unit of time (hence the phrase ‘logical time’ rather than, say, ‘historical time’). The problem of translating the analysis of Table 4.1 into suitable units of historical time is a very difficult one – and indeed it was the reason Keynes himself doubted the value of process analysis for most practical purposes (see Keynes, 1937b). This problem, however, does not deny its purpose here to establish the identity between investment and voluntary saving. 7 The concept of the ‘natural rate of interest’ is generally attributed to Knut Wicksell – see, for example, Wicksell (1907; 1935; 1936). The difference between the classical theory and Keynes’s theory of investment and saving will be discussed further in Chapter 5, but note here that Mr Meade’s Relation is still strongly contested in important contemporary policy debates, particularly by those who argue that inadequate national saving rates are the cause of low economic growth or high balance of payments deficits in some countries (see, for example, the discussions in Dalziel, 1997a; and in Dalziel and Harcourt, 1997).

5 Keynes’s revolving fund of investment finance 1 Derivations of this result within the process analysis framework of this section can be found in Dalziel (1996a, b; 1997a) and Dalziel and Harcourt (1997). For the sake of simplicity, the analysis of this section maintains Meade’s assumptions of no government and no external trade. 2 For a list of other important writers who have offered this interpretation of The General Theory, see fn. 1 of Chapter 4. 3 The following representative quote illustrates this point well: ‘Stock exchanges in all western countries, by whatever names they are called, are in effect media for the circulation of command over capital from those who hold it in a ready form to those who desire to invest it as a source of income’ (Marshall, 1923: p. 92).

Notes 4

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8 9

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Keynes’s solution was to have the rate of interest determined in the money market, so that the supply of money provided by the monetary authorities, M, is willingly held to meet the aggregate liquidity preferences of agents in the economy, L. This part of Keynes’s theory gave rise to what Hicks’s (1937) called the LL curve in his model, renamed by Hansen (1949: Chapter 5) as the LM curve. See also Keynes (1938; 1939). The revolving fund of investment finance concept became an important part of Paul Davidson’s post-Keynesian development of The General Theory, see, especially, Davidson (1968: pp. 312–8; 1972: Chapter 11; 1986), as will be discussed in the following chapter. More recently, Dalziel (1996a, c; 2000), Foster (1986; 1987), Rousseas (1986: pp. 38–5), Trevithick (1994: Part 3) and Wray (1990: pp. 116–23), have sought to revive this aspect of Keynes’s theory. The diagram is a simplified version of Figure 1 in Dalziel (1996c), which was based on the ‘circuitist’ approach to monetary analysis developed primarily in France (Parguez, 1994, for example) and Italy (Graziani, 1990, for example). An important collection of essays examining the links between this and post-Keynesians approaches to money and finance can be found in the edited volume by Deleplace and Nell (1996). At this stage it is probably easiest to think of this revolving fund as being administered by the banking system in the form of short-term loans to the investing firms which are repaid as soon as the firms sell new equities to savers. In practice, retained profits are also an important source of investment finance, but Chapter 6 will show that this does not upset the logic of the current analysis. This distinction between short-term finance and long-term funding has been emphasised by Paul Davidson (1972; 1986) and Victoria Chick (1983: pp. 262–3, and 1984). It will be discussed in more detail in Chapter 6. This article sparked an enormous controversy in a wide range of Post Keynesian journals, but in his final word on the subject Asmiakopulos (1991: p. 116) remained convinced that his argument was correct. Bibow (1995), Harcourt et al. (1995) and Dalziel (1996a) contain recent surveys of this debate.

6 Davidson’s analysis of the revolving fund 1 2

3

4

Note that Davidson uses the words ‘placements’ or ‘securities’ rather than ‘equities’ in his presentation (see, for example, Davidson, 1972: pp. 272 and 304), but I have chosen to retain the term used in this book to minimise confusion. See Keynes (1936: pp. 199–204) and Hicks (1962). In explaining L , Keynes paid 2 particular attention to what he termed the speculative demand for money, which arises when individuals consider that the current rate of interest is lower than its long-term or normal value. Such agents will sell bonds for money now in order to repurchase the bonds at a cheaper price when the interest rate rises to the expected normal value. Different agents are likely to have different views about the long-term interest rate, and it is the interaction between the bears and the bulls in this market that produces an equilibrium interest rate at which the policy-determined money stock is willingly held. This theory, although plausible, is not essential to the model and so is not explained in detail here. Note that Equation 6.1 is just the LM schedule in the standard IS–LM model of modern textbooks. Keynes’s treatment of money as an exogenous parameter in The General Theory has been the subject of some regret in recent post-Keynesian literature; see, for example, Foster (1986) and Wray (1990: p. 123). Joan Robinson tried to explain it away as a strategy by Keynes ‘to accept the presumptions of his critics in order to explode them from within’ (1970: p. 507). The material presented in this and the following two sections draws heavily on Dalziel (2000).

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5 The next section will show that as long as equities are measured in the same units as the capital stock, it does not matter for the analysis if the share market is currently valuing each equity at a different price than the price of capital goods (that is if Tobin’s q-statistic does not equal its long-run value of unity). I first came across this assumption in Darity and Cottrell’s (1987: p. 213) analysis of Meade’s (1937) early model of The General Theory. 6 Tobin’s q-statistic is the ratio of the price of existing capital goods (reflected in the market value of firm equities) divided by the price of new capital goods; see Tobin (1969) and Tobin and Brainard (1968).

7 A theory of credit-money inflation 1 See Equation 7.13. This result was first published in Dalziel (1998b; 1999; 2000), and much of the discussion which follows in this and the following chapter is based on those earlier papers. 2 Basil Moore (1994: pp. 123–4) expressed his concept as follows: ‘Newly created deposits are always demanded (accepted) so long as bank deposits retain their moneyness (general acceptability as a payments medium). To the extent bank loans are used to finance an increase in deficit spending for investment purposes, the concurrent rise in deposits provides an increase in “convenience saving”. As a result, when banks provide external finance for investment spending, saving is automatically maintained identical with investment, without any necessity for a change in interest rates, Keynesian multiplier income adjustment, lacking, or unplanned inventory accumulation or decumulation.’ This book accepts Moore’s argument for the initial period, but argues that his analysis fails to consider the subsequent process by which this ‘convenience saving’ is converted into purchases of equities and long-term ‘precautionary saving’; see Arestis and Howells (1996: Section 3) and Dalziel (1996a) for lengthier critiques of Moore’s argument. 3 It is called the marginal debt–capital ratio because it will be shown in the final section of this chapter that the price level adjusts to ensure that the average debt–capital ratio, A/PK, equals the household’s money–wealth ratio, h, rather than d. In his extension of Keynes’s revolving fund, Davidson (1972: p. 324) introduced a concept that he defined as ‘the fraction of investment expenditures (i) which entrepreneurs, in the aggregate, wish to finance externally’. As noted in Chapter 5, the concept introduced here as the marginal debt–capital ratio is simply 1 minus Davidson’s i (see also Dalziel, 2000). 4 Determining whether debt ratios are too high is a matter of prudential judgement by financial sector managers. Hyman Minsky is probably the best-known author who has analysed how changing standards of prudential judgement over time can create a financial cycle of boom and crisis (see Minsky, 1982, for example, especially Chapter 3). 5 See Keynes (1936: Chapter 15). Keynes also considered the ‘business motive’ for firms to hold liquid assets, which is not relevant here since only households demand money in this model (equivalently, the value of bank advances in Table 7.1 can be considered as being aggregated net of bank deposits held by the firms). Also, interest rates are set as an instrument of monetary policy in this book, and so there is no scope for Keynes’s speculative motive for holding money (see fn. 2 of Chapter 6). 6 Friedman (1970) went on to observe that empirical estimates of total wealth are seldom available, and so he adopted income as a proxy for a wealth index. Thus in practice his model remained close to that of Keynes. Keynes’s (1937a) summary of his theory for American audiences paid particular attention to the way in which money is valuable in dealing with uncertainty in the real world. 7 Hence the analysis in Dalziel (1999), for example, starts with these two balance sheet items without any discussion of the finance flows included in this chapter.

Notes 8

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Leading contributors to the concept of forced saving included Robertson (1926), Hayek (1932) and Wicksell (1935; 1936). Keynes (1930: p. 171, fn. 1) originally expressed some sympathy, which he retracted in The General Theory (1936: pp. 79–81). Indeed, later in the same work he condemned the theory with the following analogy (1936: p. 183): ‘The wild duck has dived down to the bottom – as deep as she can get – and bitten fast hold of the weed and tangle and all the rubbish that is down there, and it would need an extraordinarily clever dog to dive after and fish her up again.’ See, for example, Keynes (1923: pp. 37–53), Friedman (1971), Phelps (1973) and Auernheimer (1974). This result is derived within the process analysis framework of this book in Chapter 9.

8 Inflation and growth 1

2 3

4

Some readers may wonder how this is possible, given the famous Modigliani–Miller theorem that the funding decision of a particular firm cannot make any difference to the wealth of its shareholders (Modigliani and Miller, 1958; Stiglitz, 1969; Miller, 1988). That theorem works because households can always rearrange their portfolios to achieve any desired mix of financial assets independently of the firm’s decision. In this book’s model, however, the aggregate funding decision of firms creates the economy’s money stock, which is able to create inflation if it is oversupplied. This is a completely different mechanism to the problem considered by Modigliani and Miller. Note that much of the analysis in this chapter was first presented in Dalziel (1999). How this base interest rate is set by the monetary authorities is a question that is left to Chapter 10. The principle of increasing risk in the context of bank loans was first discussed by Kalecki (1937); see also Sawyer (1985: pp. 103 and 197). In more recent times, Barro (1976) and Tobin (1982) have offered similar arguments. There is a lengthy debate within the post-Keynesian literature about whether the banking system requires a higher interest rate to increase its volume of bank loans. Moore (1988c; 1991a) and Lavoie (1996) argue that it does not (the horizontalist position), but this book follows the argument made by Wray (1990: pp. 164–9), Palley (1991), Pollin (1991), Hewitson (1995: pp. 295–310) and Dow (1996a) that a higher level of loans reduces the liquidity of the banking system which requires a higher interest rate to compensate. The real business cycle literature began with Kydland and Prescott (1982). Several papers in this literature have concluded that such shocks may also cause accommodating changes in the stock of ‘inside-money’ (or credit-money as it is being termed in this book); see, for example, King and Plosser (1984), Freeman (1986), Lacker (1990), Freeman and Huffman (1991) and Farmer (1997). This conclusion is consistent with the argument being advanced in this paragraph.

9 Fiscal deficits and inflation 1

2

Some readers may recognise parallels between this approach and the chartalist theory of money recently discussed in a modern context by Wray (1998, especially Chapter 4). The essence of the chartalist theory is that if fiat-money is the only asset that the government will accept in settlement of tax liabilities, then ‘the government does not “need” the public’s money in order to spend; rather the public needs the government’s money in order to pay taxes’ (Wray, 1998: p. 18). See, for example, Feldstein (1974: pp. 922–3) and Poterba and Summers (1987). This does not deny that private sector investment may be crowded out by public sector deficits through some other mechanism (for example, if the deficits reduce business

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Notes confidence or cause interest rates to be higher than they otherwise would be); it does deny, however, that inadequate saving can ever be the culprit. See, for example, Christ (1967; 1969; 1987). This point has been made in a series of papers by Wallace (1981), Sargent (1982), Sargent and Wallace (1981; 1982; 1983), Smith (1985; 1988) and Sargent and Smith (1987). This possibility, and some of the conditions under which it will be satisfied, have been analysed in a number of papers, including Spaventa (1987), Erbas (1989) and Buiter and Kletzer (1992). Alternatively, this assumption could be derived from a constrained utility maximisation model as was used to derive the H = hPK result in Equation 7.6. Note also that the fiatmoney, F, supplied by the central bank to finance a period’s initiating deficit is willingly held by agents to finance the multiplier process flows of the following interval and so has no effect on the model’s equilibrium analysis, in exactly the same way as occurred in Equations 7.8 and 7.9 of the analysis in Chapter 7. This terminology has been retained in the modern-day literature beginning with Friedman (1971), Phelps (1973) and Auernheimer (1974). See, for example, Bruno and Fischer (1990), Dixit (1991) and Lee and Ratti (1993) for analyses of the former and Kimbrough (1986; 1989), Imrohoruglu and Prescott (1991) and Guidotti and Végh (1993) for analyses of the latter issue.

10 Monetary policy and price stability 1 In line with the endogenous money theory of this book, there is no suggestion that this series is under the direct control of the central bank, but it remains a useful indicator of changes in monetary conditions. 2 See Hawke (1973) and Dalziel (1993) for lengthier discussions about how this clause has evolved over the lifetime of the Reserve Bank of New Zealand. 3 Two recent articles describing the development of New Zealand’s monetary policy framework are Reddell (1999) and Sherwin (1999). An earlier collection of Reserve Bank papers on this and related topics was edited by Grimes (1992), and RBNZ (1999) contains the Reserve Bank’s views on the general principles behind the monetary policy framework at the time of the November 1999 general election. A political economy analysis comparing Australian and New Zealand developments in monetary policy over this period is provided by Eichbaum (1999b). Dalziel (1997b; 1998c) presents recent critical discussions on New Zealand’s monetary policy. 4 Although New Zealand is perhaps unusual in not having any statutory obligation to have regard to other economic objectives. The European System of Central Banks, for example, is obliged to ‘support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community’, although ‘without prejudice to the primary objective of price stability’. This difference should not be overemphasised, however. The Reserve Bank itself considers that ‘the ultimate objective of monetary policy, and the institutional framework within which it operates, is to contribute to economic growth and higher living standards for New Zealanders’ (RBNZ, 1999: p. 11). Perhaps more controversially, the Policy Targets Agreement used to state simply that maintaining a stable general level of prices is how ‘monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy’ (idem: p. 48). This was supplemented in a new PTA dated 16 December 1999 after the change of government in the 1999 general election, which added a requirement that ‘In pursuing its price stability objective, the bank...shall seek to avoid unnecessary instability in output, interest rates and the exchange rate’. 5 Guthrie and Wright (2000) have termed this policy regime as ‘open mouth operations’.

Notes

147

6

Milton Friedman (1956; 1970; 1987) provides an authoritative description of this version of the theory. 7 Note that there is no LM schedule in the diagram, since interest rate targeting means that the nominal money stock is supplied endogenously to the level demanded at the set rate of interest. In Moore’s (1988c) sense, the LM schedule is effectively horizontal at îb. 8 The new bank deposits created to finance current investment expenditure is excluded for the reasons discussed in Chapter 7 – they are matched by the transactions demand for money to finance consumption expenditure (that is convenience saving) in the resulting income–expenditure multiplier process. 9 See, for example, Minsky (1976: p. 168), Dow and Earl (1982: Chapter 17), Dow (1986) and Rousseas (1986: Chapter 6). 10 See Eichbaum (1999a: pp. 19–23; 1999b: pp. 380–6) for a further discussion. 11 The importance of credibility has received a lot of attention in the monetary policy literature; see, for example, the review by Blackburn and Christensen (1989) and the more recent survey of central bank and academic opinions reported in Blinder (1999). To provide another recent illustration, Sims (1999) has shown that the commercial paper rate in the United States became very sensitive to changes in commodity prices (a reasonable leading indicator of consumer price inflation) during the Volcker disinflation of the early 1980s. If Volcker’s task was to establish credibility for his strong disinflationary stance, this empirical result is consistent with the hypothesis suggested in this paragraph.

11 Conclusion 1

2 3 4 5 6 7

In appropriating this term, I should acknowledge that although Freeman and Huffman (1991) call bank deposits ‘intermediated capital’, they also argue that bank deposits are not money precisely because they are not a commodity. Fisher (1911) made a similar distinction (see Chapter 2). I have not accepted this argument. If bank deposits are the liquid asset acting as the economy’s generally accepted medium of exchange, then in my view they should be acknowledged as being ‘money’. See the lengthier discussion in Chapter 3 of this book. This section draws heavily on Dalziel (2000). A more general utility function would allow the precautionary demand for money as a stock to depend on items such as the expected inflation rate, but this has not been attempted in the present study. Note that this is close to the mechanism of Arestis and Howells discussed earlier in the chapter. The main difference, however, is that the mechanism here is not automatic, but must be implemented by the central bank, acting as ‘the conductor of the orchestra’. For critical assessments of the use of monetary conditions indices in monetary policy, see Eika et al. (1996) and Burnell (1998). A more sympathetic discussion is provided by Mayes and Razzak (1998). These observations are drawn from Dalziel (1998c).

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Index

Ahiakpor, James C. W. 142 Akerlof, George, et al. 139 Alesina, Alberto 6 Alternative Theories of the Rate of Interest (Keynes, J. M.) x Arestis, Philip: credit segment of UK post-Keynesian model (notes) 141; on credit-money and inflationary pressures 10; credit-money and liquidity preference 22; credit-money supply and deposits (notes) 141; credit-money, supply/demand equilibrium 39–40; financial innovation and the credit-money supply function 36; future returns, constancy of 125; insightfulness of xiii; institutional developments and monetary policy 35; macrodynamics through post-Keynesian models (notes) 141; on money and banking (notes) 140; post-Keynesian alternatives (notes) 140; postKeynesian theory of money, credit and finance 35, 36; on saving, convenience and precautionary (notes) 144; recent work by 12; on wage determination (notes) 139 Argy, Victor, et al. 139 Asimakopulos, Athanasios 61, 62, 143 Auernheimer, Leonardo 105, 145, 146 Australia 3–5, 122 Bailey, Roy E. 26 balance sheets: aggregate and expanded aggregate for firms and households 77; aggregate of firms, impact of inflation on 88–90; Bank of England Issue Department (February 1999) 29; Barclays Bank PLC (December 1998) 30; conceptual, of public sector 103;

non-bank economic agent 34; public sector, budget deficits and the 102–4; retained profits and 71; UK banks, aggregated (February 1999) 30 bank deposits: Black on adjustment of 22, 33; Fisher on money and 11, 16–17, 147; Fisher on the equation of exchange and 18–19; Friedman on inflation and 75; Keynes on monetary analysis and 11, 16–17; Lavoie on 21; Tobin on public preference 21–2; Tobin on retirement of loans and 75; see also capital; credit-money; money; equities; saving Bank of England 6, 29 Bank of Ireland Annual Report (1999) 6 banking: evolution of 26–7; failures in 32–3; risks in 31–2; see also central banking; financial innovation Barnett, William A. 20 Barro, Robert J. 6, 36, 103, 140, 145 Beaumont, Craig 112 Bernanke, Ben S. 139, 140 Bhaskar, Roy 43–5 Bilbow, Jörg 143 Black, Fischer: bank deposit adjustment 22, 33; finance theory of money 11, 17; inflation and self-fulfilling expectations 3; money and payments 24, 75 Blackburn, Keith 147 Blanchard, Olivier J. 139 Blinder, Alan 147 Boggess, Trent E. 26 Bordo, Michael D. 18, 140 Boschen, John F. 18, 22 Boughton, James M. 20 Brainard, William C. 24, 129, 144 Bridel, Pascal 1, 56 broad money supply: growth of 109–10;

Index liquidity preference and 22; nominal growth (New Zealand 1959–99) 109 Brown, Charles, et al. 44 Brunner, Karl 19, 24 Bruno, Michael 139, 146 budget deficit: a process analysis of a 99–102; public sector balance sheet and 102–4; Tobin’s argument for 101 Buiter, Willem H. 103, 146 Burnell, Stephen 147 Cagan, Phillip 21, 140 Calmfors, Lars 9 Calmfors-Driffill thesis 9 Canada 3–5 capital: adequacy ratios of 36; assets and the demand for money 41; exogenous shocks to the marginal efficiency of 97; marginal efficiency of 91; rate of return on 141; see also bank deposits; credit-money; equities; money; saving central banking: legislation for 1; role of 35, 124; structuralist approach to 36; see also banking; financial innovation Ceteris Paribus, the pound for disturbing causes 46 Chari.V. V., et al. 21 Chick, Victoria: banks, evolution of 26–7; financial innovation and credit-money supply function 36; financial innovation and Reserve Bank cash targets 112; inflation and bank lending 42; inflation and endogenous money supply 12; insightfulness of xiii; monetary policy and institutional change 27; money balances, elimination of excess 37; process analysis, advocation of use of (notes) 142; on short-term finance and long-term funding (notes)143 Christ, Carl F. 146 Christensen, Michael 147 Christiano, Lawrence J., et al. 21 classical theory, Keynes and 56–8 Clower, Robert 17–18 Cobb–Douglas utility function 116 collateral and liquidity 34–5, 125 commodity theory of money 124 ‘compensated dollar’, Fisher plan for 140 convenience lending/saving 38, 77, 144 Cooper, Richard N. 140 Cornwall, John 9, 139 corporate raiders 87 Cottrell, Allin F. 22, 37, 139, 140–2, 144

171

Cowen, Tyler 24, 25 ‘credit channel’ literature 140 credit-money inflation, a theory of: inflation, saving and 83–6; introduction to 75–6; model structure for 76–8; money market equilibrium and 81–3; notes on 144–5 credit-money: decisions affecting excess supply 39; demand for 79–81; expansion by central banks 1, 3, 35–6; and fiat-money, a combined model 106–7; ‘horizontalist’ position on 22; inflation and 28–42, 140–1; as ‘intermediated capital’ 125; liquidity preference and 22; pressure of inflation and 10; revolving fund and two period model with 74; supply and demand equilibrium 39–40; supply of 78–9; two-period model of Keynes’s revolving fund with 74; see also bank deposits; capital; equities; money; saving credit, pure system of (Wicksell) 25–6 Cripps, Francis 141 critical realism: process analysis and 43–52, 142; underlying mechanisms and 44, 46–7 Cross, Rod 46 current money, Keynes on 19 Dale, Spencer 112 Dalziel, Paul: broad money supply, growth of 109–10; conclusions 124–35, 147; credit-money and inflation 28–42, 141; critical realism and process analysis 43–52, 142; equity prices and real wages 131; fiscal deficits and inflation 98–107; inflation and growth 87–97, 145; investment finance, Keynes’s revolving fund of 53–74, 142, 143–4; Mr Meade’s Relation, algebraic confirmation of 55; monetary experience, New Zealand (mid-1990s) 135; monetary policy and price stability 108–23, 146; money, what is it? 16–27, 140; price stability, the quest for 1–17, 139; price stability, unemployment and growth 118; pushing forward Keynes’s rich analysis viii; saving, conservation principle of 51; stock market values and Tobin’s q-statistic 130; a theory of credit-money inflation 75–86, 144 Darity, William A. 144

172

Index

Davidson, Paul: analysis of Keynes’s revolving fund of investment finance 64, 65–74, 142–4; credit-money and inflation (notes) 141; on credit-money and inflationary pressures 10; creditmoney inflation, a theory of (notes) 144; critical realism and process analysis (notes) 142; encouragement from xiii; endogenous money and inflation 40; endogenous money stocks and control of inflation 22; endogenous money supply, increases in 38; household ‘hoarding’, impact of 13; inflation and capital accumulation 92; inflation and income distribution conflict 3; liquidity preference and the revolving fund 67–70; retained profits and Tobin’s q-statistic 70–2; revolving fund, two-period model with instantaneous multiplier 73–4; saving and money 77; supply of equities to savers 72–3; unemployment and credit expansion 35 Davutyan, Nurhan 140 Dawe, Stephen 6 De Vroey, Michel 41 Deane, Rodrick, et al. 139 Debreu, Gerard 43 debt–capital ratio, marginal: equilibrium growth rate and optimisation 95; optimal locus 94; optimisation of 90–93 deficit, budget: process analysis of a 99–102; public sector balance sheet and 102–4 Deleplace, Ghislain 140, 143 demand for credit-money 79–81 demand side restraint on monetary expansion 21–3 Deriet, Mark 141 Dicks, Michael J. 33 Dixit, Avinash 146 Dotsey, Michael 18 Douglas, Roger 111 Dow, Alastair C. 41 Dow, Sheila C.: broad money supply and liquidity preference 22; capital adequacy ratios 36; capital assets and demand for money 41; credit-money and inflation (notes) 140, 141; critical realism and process analysis (notes) 142; endogenous money and inflation 40; financial innovation and the creditmoney supply function 36; inflation

and growth (notes) 145; insightfulness of xiii; monetary policy and price stability (notes) 147; money, what is it? (notes) 140; on process truth realism 43; on structural change (and stability) 47 Dow, J. C. R. 141 Dow, James P. 140 Dowd, Kevin 21, 22, 25, 140 Driffill, John 9 Driver, Ciaran 141 Dwyer, Gerald P. 21 Eagly, Robert V. 26 Earl, Peter xiii, 36, 40, 140, 147 Eckstein, Otto 139 Economic Journal. 53 economic laws, nature and limitations of 45 economic society, Keynes’s view of major faults in 135 EFTPOS (electronic funds transfer at point of sale) 16, 24, 75 Eichbaum, Christopher 122, 146, 147 Eichner, Alfred S. 123, 139, 140 Eika, Kari, et al. 147 Eisner, Robert 103 Employment, Interest and Money, The General Theory of see General Theory endogenous money: eliminating excess supply of 37–40; increases in supply of 38; inflation and 12, 22, 40–2; vs. exogenous models 3 equilibrium analysis 47–9 equilibrium growth rate, optimal marginal debt–capital ratio and 95 equilibrium inflation and growth 93–6 equities: alternative financial assets 67; prices of, and consumer prices 122–3; prices of, and real wages 131; supply to savers of 72–3; see also bank deposits; capital; credit-money; money; saving Erbas, S. Nuri 146 European Monetary System (EMS) 4, 139 Evans, Gary R. 36 The ‘Ex Ante’ Theory of the Rate of Interest (Keynes, J. M.) x exchange and interest rates (New Zealand, 1990–99) 135 exogenous money: theories of 6–11; nominal supply of 1; and shocks to the marginal efficiency of capital 97; vs. endogenous models 3 expansionism, cautious 119–22

Index Fama, Eugene F. 18, 24 Farmer, Roger E. A. 22, 145 Feige, Edgar L. 19, 20 Feldstein, Martin 145 fiat-money: and consumer utility functions 17–18; and credit-money, a combined model of 106–7 finance theory of money 11, 17, 124–5 financial assets, money and long-term debt 66 financial deregulation 36 financial innovation: credit-money supply function, and the 36; portfolio choice and 24; Reserve Bank cash targets and 112; see also banking; central banking financial instability hypotheses 40 fiscal deficits and inflation 98–107, 145–6 Fischer, Stanley 17, 26, 140, 146 Fisher, Irving: bank deposits and money 16–17, 147; bank deposits and the equation of exchange 18–19; bank deposits in monetary analysis 11; collateral and liquidity 34–5, 125; compensated dollar plan (notes) 140; money, primary and fiduciary 18; quantity theory of money and 1, 75, 83 Fisher, Douglas 21 Fleetwood, Steve xiii, 43 Fleissig, Adrian A. 20, 21 Foley, Duncan K. 24 Folkerts-Landau, David 33 foreign exchange market: and economy, small open 132; higher domestic interest rate and 133 Forman, Leonard, et al. 141 Forrest, David 44 Foster, Gladys Parker 141, 143 Fouraker, Lawrence E. 48, 49 Fraser, Bernie W. 6 Freeman, Scott 17–18, 21–2, 125, 145, 147 Friedman, Milton: bank deposits and inflation 75; cash-carrying helicopters 124, 140; commodity theory of money 124; credit-money inflation, a theory of (notes) 145; inflation and monetary growth 6; inflation tax 14, 146; inflationary expectations and nominal interest rates 70; ‘instrumentalist’ position of 45; interest rates, nominal and real 26; monetary base, control of 21; money and demand deposits 19; money, broad definition of 20; precautionary holdings 80; quantity

173

theory of money 1, 147; total wealth, empirical estimates of 144 Friedman, Benjamin 5 Friedman, Rose 6 Fuerst, Timothy S. 21, 22 Fuhrer, Jeffrey C. 26 funding decisions (of firms): long-term empirical determination of, difficulties with 87; long-term incompatibility with households’ liquidity preferences 75–86; long-term short-term finance and (notes) 143 future returns, constancy of 125 Gardener, Edward P. M. 36 Gedeon, Shirley J. 35, 41–2, 141 The General Theory of Employment, Interest and Money (Keynes, J. M.): capital goods, exclusion from theory of liquidity preference 40–1; classical economics and 56–8, 142; Dalziel, pushing forward the rich analysis of viii; equilibrium analysis in 47–9; essential policy component in 70; forced saving (notes) 145; fundamental new result in 43; Minsky’s critique of 67; money as exogenous parameter in (notes) 143; old ideas, escaping from 51; prices, theory of 115; process analysis and xi, 12; process analysis in 47–9; public investment and state intervention 103; saving and consumption 52; saving and investment 53; saving conservation principle 55–6; saving, decision and form 65–6; short-tern finance/long-term funding 72–3 Gertler, Mark 15, 140 Gilchrist, Simon 140 Girton, Lance 23 Glasner, David 21, 33, 75 Godley, Wynne 141 Goodhart, Charles 21–2, 32, 46, 112, 140, 141 Gootzeit, Michael J. 26 Gordon, David B. 6 government’s inflation tax 14, 104–6, 146 Gramm, William P. 17 Graziani, Augusto 10, 140, 143 Greenfield, Robert L. 17, 24, 25 Greenspan, Alan 6 Grimes, Arthur 146 Grossman, Herschel I. 7 Grossman, Sanford 21

174

Index

growth: equilibrium inflation and 93–6; inflation and 87–97, 145; nominal, of broad money supply (New Zealand 1959–99) 109 Guidotti, Pablo E. 146 Gurley, John G. 23, 75, 124 Guthrie, Graeme 147 Hadjimichalakis, Michael G. 26, 140 Haldane, Andrew G. 18, 112 Hall, Robert E. 18, 24 Hansen,A. H. 143 Harcourt, Geoffrey C. viii–ix, xiii, 55, 139, 142, 143 Hargreaves-Heap, Shaun P. 9 Hawke, Gary 146 Hayek, Friedrich A. 22, 142, 145 Heise, Arne 141 Hewitson, Gillian 22, 140, 141, 145 Hicks, John R.: critical realism and process analysis 142; fiat-money and consumer utility functions 17–18; on Keynes and the classics 56; Keynes’s revolving fund, analysis of (notes) 143; liquidity and capital values 20; liquidity demand, introduction of 66; money, what is it (notes) 140; price stability, the quest for (notes) 139 Higgins, Jane viii, xiii Holden, Kenneth, et al. 139 Honohan, Patrick 26 Hoover, Kevin D. 22, 24 household ‘hoarding’ 13 Howells, Peter: credit-money and inflation (notes) 140, 141; creditmoney, supply and demand equilibrium 39–40; insightfulness of xiii; money, excess supply and equity prices 125; recent work by 12; reconciliation problem of 37 Huffman, Gregory W. 17, 18, 22, 125, 145, 147 Humphrey, Thomas M. 26, 140 Husted, Steven 20 Imrohoruglu, Ayse 146 income levels and investment quantity 57–8 income–expenditure multiplier framework (Meade) 42 incomes policy 4–5 indeterminacy of price 24–5 inflation: aggregate demand and 3; bank lending and 42; capital accumulation

and 92; causes of 9; central bank control and 3; consumer prices, English-language OECD countries 2, 3; control of, through monetary restraint 115–19; creation of endogenous money and 40 inflation, credit money and (notes) 140–41; endogenous money and 12, 22, 40; endogenous money stocks and 22; endogenous money supply and 12; equilibrium and growth 93–6; expectation and nominal interest rates 70; fiscal deficits and 98–107, 145–6; growth and aggregate marginal debt–capital ratio 87–97; impact on the balance sheets of firms 88–90; income distribution conflict and 3; irony in targeting of 115; monetary growth and 6, 10; a monetary phenomenon 6–7; pre-announced and low targets for 1; rise and fall of (late twentieth century) 3–6; saving and 83–6; self-fulfilling expectations and 3; targeting of 1, 5–6, 115; tax 14, 104–6, 146; see also monetary policy instantaneous multiplier: Keynes’s revolving fund with a 63; two-period model with a 73–4 interest rates: base rates 1, 3; and exchange rates (New Zealand 1990–99) 135; nominal and real 26; responsiveness effects, price stability with 119 intervention, public investment as instrument of 47 Introduction to the Theory of Employment (Robinson, J.) xii investment finance, Keynes’s revolving fund of 58–64, 142–4 investment quantity, income levels and 57–8 Ireland 3–5, 139 Ireland, Peter N. 24 IS-LM AS-AD theoretical framework for monetary policy 114, 115 Johnson, Harry G. 17, 19, 27 Jones. Robert A. 17 Jonung, Lars 18, 140 Joplin, Thomas 140 Journal of Economic Surveys xii, 139–40 Journal of Post Keynsian Economics xii, xiii

Index Kahn multiplier: Meade’s Relation and 49–52; operation of 48–9 Kahn, Richard 12, 42, 49, 51, 142 Kaldor, Nicholas: central bank, role of 35; credit-money and inflation (notes) 141; credit-money, ‘horizontalist’ position on 22; critical realism and process analysis (notes) 142; income distribution model of 41; inflation and aggregate demand 3; inflation and endogenous money stocks 22; inflation and money supply growth 10; money market equilibrium, unsatisfactory nature of 67; multiplier process 61–2 Kalecki, Michal 13, 36, 41, 141, 145 Kennedy, Kieran A., et al. 139 Keynes, John Maynard: bank deposits and monetary analysis 11, 16–17; capital goods and liquidity preference 41; capital, marginal efficiency of 91; central bank, role of 124; classical theories and 56–8; credit-money and inflation (notes) 141; credit-money inflation, a theory of (notes) 144; credit-money, revolving fund and two-period model with 74; critical realism and process analysis (notes) 142; current money 19; equilibrium analysis 47–9; equilibrium inflation and growth 93; equities as alternative financial assets 67; genius of 48; inflation tax 14, 105; liquidity and capital values 20; liquidity preference 79; money, definition of 28; money, flow demand vs. stock demand for liquidity 81; old ideas, escape from 51–2; outstanding faults of economic society 135; precautionary holdings 80; prices, theory of 115; public investment as instrument of intervention 103; revolving fund of investment finance 53, 58–74, 142–3; savers, supply of equities to 72–3; saving and consumption 52; saving, enforcement of (notes) 145; saving, investment and ‘free-will’ 55–6; savings and investment 53, 101; savings and liquidity preference 65–6; peculative demand for money (notes) 143 Keynes’s revolving fund of investment finance: core theoretical framework (of this book) 64; Davidson’s analysis of 64, 65–74, 142–4; generality of Mr Meade’s Relation and 53–6; interest

175

for endogenous money theorists 53; liquidity preference and 67–70; outline of 58–64; retained profits, Tobin’s qstatistic and 70–2; supply of equities to savers and 72–3; two-period model with instantaneous multiplier 73–4 Kimbrough, Kent 146 King, Mervyn 112 King, Robert G. 22, 145 Kiyotaki, Nobuhiro 17 Klein, Benjamin 22, 23 Kletzer, Kenneth M. 103, 146 Kohn, Meir 48, 140 Kregel, Jan A. 123, 139, 140 Kroszner, Randall 24, 25 Kuttner, Kenneth 5 Kydland, Finn E. 7, 22, 145 Kydland–Prescott model, monetary restraint and unemployment 7–8, 110 Lacker, Jeffrey M. 145 Laidler, David 19, 140 Lattimore, Ralph 109–10 Lavoie, Marc: bank deposits 21; central bank, role of 35; credit-money and inflation (notes) 140, 141; credit-money, ‘horizontalist’ position on 22; inflation and growth 10–11, 145; reflux, and law of 33; structuralist vs.accommodationist traditions in central banking 36 Lawson, Tony xiii, 43–6, 142 Layard, Richard 139 Le Bourva, Jacques 40 Lee, Kiseik 146 Lindbeck, Assar 44 Lindgren, Carl-Johan 33 liquidity and capital values 20 liquidity demand, Hicks’s introduction of 66 liquidity preference: capital goods and 41; Davidson’s analysis of Keynes’s revolving fund and 66–70; of households, incompatibility with firms’ long-term funding decisions 75–86; Keynes on 79; money and long-term debt 66–7 Loasby, Brian J. 142 locus, optimal marginal debt–capital ratio 94 Lucas, Robert E. 18, 46 McCallum 18, 25 macroeconomic experience 3 Mäki, Uskali 43

176

Index

marginal debt–capital ratio: inflation, growth and the economy’s aggregate 87–97; optimisation problems 90–3 marginal efficiency of capital, exogenous shocks to the 97 market for foreign exchange: effect of higher domestic interest rate on 133; small, open 132 Marselli, Riccardo 141 Marshall, Alfred 45, 46, 53, 56, 81, 142 Marty, Alvin L. 19–20 Mayes, David 147 Meade, James E.: critical realism and process analysis 142; Davidson’s analysis of Keynes’ revolving fund and 144; equilibrium analysis 48; incomeexpenditure multiplier framework of 42 Medium Term Financial Strategy 4 Melzer, Allan H. 19, 24 Menger, Karl 16, 17 Messori, Marcello 141 Miller, Edward M. 20 Miller, Merton H. 145 Miller, Stephen M. 24 Mills, Gordon 80 Mills, Leonard O. 22 Minford, Patrick 44 Minsky, Hyman: capital assets and the demand for money 41; credit-money and inflation 141, 144; endogenous money supply and price inflation 12; equities as alternative financial assets 67; financial instability hypothesis 40; monetary policy and price stability 147; portfolio choice and financial innovation 24; processes, functioning within institutions 47; structuralist approach to central banking 36 Mishkin, Frederic 139 models: combined, of fiat-money and credit-money 106–7; constrained utility maximisation 146; IS-LM AS-AD framework 114, 115; Kaldor’s, of income distribution 41; of small open economy 132–5; structure for a theory of credit-money inflation 76–8; two-period, of Keynes’s revolving fund with credit-money 74 Modigliani, Franco 145 Modigliani–Miller theorem 145 monetary aggregates, control of 1 monetary circuit: production and consumption of goods 38; production of investment goods 59

Monetary Conditions Indicator (MCI) 112–13 monetary expansion, causes of 9–11 monetary policy: control of monetary base 21; distinct schools of thought on 124; employment, growth and 118; important questions for 115; inflation control and 9; institutional change, and 27; institutional developments and 35; interest rate changes and 113–14; interest rates, and 24; IS-LM AS-AD theoretical framework for 114, 115; New Zealand experience 109–15; price stability and 108–23, 146–7; primary purpose of 110; real economic growth and 3; see also inflation Monetary Policy Statement (of Reserve Bank of New Zealand) 111 monetary restraint, control of inflation through 115–19 monetary targeting 4–5, 21 Money and the Real World (Davidson, P.) x money creation, the process of 28–33 Money in a Theory of Finance (Gurley, J. G. and Shaw, E. S.) xi money market equilibrium: credit-money inflation and 81–3; unsatisfactory nature of 66–7 money: all generally accepted media of exchange 18–23; banking system restricted in creation of 33; and banking, changes in practice of 26–7; classical concept of 16–18; concluding comment on theoretical approach to 26–7; credit and finance, postKeynesian theory of 35, 36; definitions of 19–21, 28; demand deposits and 19; elimination of excess balances 37; excess supply and equity prices 125; a financial asset 23–6; Friedman’s broad definition of 20; Keynes’ current money 19; Keynes’ definition of 28; major shortcoming of system of 17–18; and non-money 18–19; origin of 16; payments and 24, 75; primary and fiduciary 18; quantity theory of 1, 3, 75, 83, 147; restraint on expansion of 21–3; saving and 77; a special commodity of exchange 17–18; speculative demand for 143; stock demand for liquidity and flow of 38, 67, 81; what is it? 16–27, 139–40; see also bank deposits; capital; credit-money; equities; saving

Index Money, Credit and Price Stability (this book): core theoretical framework for 64; outline of 11–15 Moore, Basil J.: central bank, role of 35; convenience lending 38; convenience saving 77, 144; credit-money and inflation (notes) 140, 141; credit-money, ‘horizontalist’ position on 22; financial innovation and cash balance needs 112; inflation and endogenous money creation 40; inflation and growth 10, 145; monetary policy and price stability (notes) 147; money market equilibrium, unsatisfactory nature of 66–7; price stability, the quest for 139 Moore, George R. 26 Mr Meade’s Relation 49–52, 53–6, 84, 142; algebraic confirmation of 55; description in detail of 49–52; generality of 53–6; inflation, saving and 84; price stability, the quest for 139; process analysis of 50; savings, investment and tail wagging dogs 58; strongly contested 142 Muldoon, Sir Robert 109 Mullineux, Andrew 20–21 multiplier see instantaneous multiplier; Kahn multiplier multiplier processes: Kahn multiplier, operation of 48–9; Kaldor on 61–2 Myatt, Anthony 141 Nell, Edward J. 140, 143 new monetary economics 24–5 New Zealand 3–5, 108–14, 122, 132–5 Newlyn, Walter T. 19 Niggle, Christopher J. 140, 141 notation, appendix on 136–8 OECD (Organization for Economic Cooperation and Development) 2–3, 26 official cash rate (OCR) system 112–13 Ohlin, Bertil 58 open economy, small, model of 132–5 optimal marginal debt–capital ratio: equilibrium growth rate and the 95; inflation, growth and the 90–93; locus of 94 optimal policy mix and cautious expansionism 119–22 Ostroy, Joseph M. 17 Oxley, Les 140

177

Palgrave, The New: A Dictionary of Economics (Eatwell, J., Milgate, M., and Newman, P., eds) 1 Palley, Thomas I. 141, 145 Parguez, Alain 143 Parke, William F. 140 Patinkin, Don 18, 19, 23, 75, 140 Pearce, Douglas K. 19, 20 Pearce, Ivor 42 Pesek, Boris P. 19 Phelps, Edmund S. 145, 146 Phillips curve, productivity shocks and the 96–7 Plosser, Charles I. 22, 145 Podolski, Tad M. 24 Policy Targets Agreement (PTA, New Zealand) 111, 146 policy, optimal mix and cautious expansionism 119–22 Pollin 35, 36, 141, 142, 145 Poloz, Stephen 6 Poole, William 113 Poterba, James M. 145 précis of model and policy implications 127–31 precautionary holdings 80 Prescott, Edward C. 7, 22, 145, 146 Pressman, Steven 103 price indeterminacy 24–5 price stability: commitment and consistency to 8; interest rate responsiveness effects and 119; monetary policy and 108–23, 146–7; quest for 1–15, 139 prices: equity and consumer 122–3; Keynes’s theory of 115 principles, summary of key (and policy implications) 127–9 process analysis: budget deficit, of 99–102; Chick’s advocation of 142; critical realism and 142; equilibrium analysis and 47–9; Keynes’s revolving fund of investment finance and 60; Mr Meade’s Relation and 50; role of, in Keynes’s methodology xi, 12 productivity shocks and the Phillips curve 96–7 profits, retained 70–72 public investment as instrument of intervention 103 public sector balance sheet, budget deficits and the 102–4 The Purchasing Power of Money, The (Fisher, I.) 18 pure credit system (Wicksell) 25–6

178

Index

The Radcliffe Report (Committee on the Working of the Monetary System) 20 Ratti, Ronald A, 146 Razzak, Weshah 147 real wages, equity wages and 131 Reddell, Michael 111, 112, 146 reflux, law of 33–7 The Relation of Mr. Meade’s Relation to Kahn’s Multiplier (Meade, J. E.) x, xi, 11, 12 Reserve Bank of Australia 6 Reserve Bank of New Zealand 108–14, 139, 146 Reserve Bank of New Zealand Act (1989) 109–15 retained profits 70–2, 143 revolving fund of investment finance 58–64, 142–4 Ricardo, David 86 risk, principle of increasing 36–7, 145 Robb, A. Leslie 20 Robertson, Dennis H. 61, 145 Robinson, Austin 51, 142 Robinson, Joan: critical realism and process analysis (notes) 142; Davidson’s analysis of Keynes’s revolving fund (notes) 143; equilibrium analysis 47; inflation and endogenous money stocks 22; inflation and money supply growth 10; on Keynes’s didactic style 48 Rockoff, Hugh 17 Roper, Don 23 Rose, Hugh 25, 26, 140 Rotemberg, Julio J. 21 Rousseas, Stephen 139, 140, 141, 143, 147 Runde, Jochen 20 Rush, Mark 20 Sachs, Jeffrey 139 Samuelson, Paul A. Sarel, Michael 139 Sargent, Thomas J. 103, 146 savers, supply of equities to 72–3 Saville, Iain D. 141 saving: capital accumulation and 52; conservation principle of 51, 55–6; consumption and 52; convenience and precautionary 144; decision and form 65–6; enforcement of 145; inflation and 83–6; liquidity preference and 65–6; money and 77; supply of equities to

savers 72–3; see also bank deposits; capital; credit-money; equities; money saving and investment: analysis of identity between 53, 101; classical theory of 57; and ‘free-will’ 55–6; and tail wagging dogs 58 Saving, Thomas R. 19, 21, 23 Sawyer, Malcolm C. 36, 40, 141, 145 Sayer, Derek 43 Schelling, Thomas C. 17 Schnadt, Norbert 25 Schumpeter, Joseph A. 48 Schwartz, Anna J. 19, 20, 75, 140 Seccareccia, Mario 141 Selgin, George A. 21–5, 141 Serletis, Apostolos 20 Shaw, Edward S. 23, 75, 124 Sherwin, Murray 146 Sidrauski, Miguel 24 Siegel, Barry N. 140 Siegel, Jeremy J. 105–6 Sims, Christopher A. 147 Skidelsky, Robert 142 Skott, Peter 139 small open economy model 132–5 Smith, Bruce D. 146 Smith, Vera C. 22 Smithin, John N. 103 Snower, Dennis J. 18 Spaventa, Luigi 146 Sraffa, Piero 142 Stein, Jerome L. 26 Stiglitz, Joseph E. 109, 121, 145 stock market values vs. real asset values 129–30 Stockton, David J. 139 Stokey, Nancy L. 18 Structuralist School 41 summary of policy conclusions 127–9 Summers, Lawrence H. 139, 145 Sumner, Scott 18, 140 supply of credit money 78–9 supply of equities to savers 72–3 supply-side restraint on monetary expansion 21–3 Swofford, James L. 20 Tabellini, Guido 6 tax, government’s inflation 104–6 Taylor, Lance 41 a theory of credit-money inflation 75–86, 144–5 Thornton, Henry 140 Threadgold, Andrew 140–41

Index Timberlake, Richard H. 23 Tobin, James: bank deposits and public preference 21–2; bank deposits and retirement of loans 75; budget deficit, argument for 101; inflation and endogenous money stocks 22; liquidity and capital values 20; monetary policy and interest rates 24; price stability, the quest for (notes) 139; q-statistic of 70–2, 129–30, 144; reflux, and law of 33; risk, principle of increasing 36, 145; stock market values vs. real asset values 129 Tobin’s q-statistic: outline of 129–30; retained profits and 70–72: stock market values and 130 Treatise on Money, Vol. I: The Pure Theory of Money (Keynes, J. M.) viii, 19, 124 Trevithick, James A. 22, 141, 142, 143 two-period model (Keynes’s revolving fund) with an instantaneous multiplier 73–4 unemployment and credit expansion 35 United Kingdom 3–5, 28, 29 United States 3–5, 122 US Federal Reserve 4, 140 utility maximisation, constrained model 146 Végh, Carlos A. 146 Volcker, Paul A. 147 Wallace, Neil 146 Waller, Christopher J. 7 Wallich, Henry C. 139

179

Walsh, Carl E. 24 Weale, Martin, et al. 139 Weintraub, Robert E. 3, 10, 22, 35, 40, 140 Weiss, Laurence 21 Wells, Paul 61 Whitaker, John K. 17 White, Lawrence H. 18, 22, 24, 25, 140 Whittaker, John 25 Whitwell, Jan 134 Wicksell’s pure credit system 25–6 Wicksell, Knut 11, 25–6, 56, 140, 142, 145 Wilkinson, Frank 44 Winnett, Adrian 42 Wojnilower, Albert M. 24, 36 Woodford, Michael 26 Woolsey, W. William 24, 25 Wray, L. Randall: broad money supply and liquidity preference 22; capital assets and the demand for money 41; credit-money and inflation (notes) 140, 141; Davidson’s analysis of Keynes’s revolving fund (notes) 143; financial instability hypothesis 40; fiscal deficits and inflation 145; inflation and growth (notes) 145; Keynes’s revolving fund of investment finance and 143; money flow and stock demand for liquidity 38, 67, 81 Wright, Julian 147 Wright, Randall 17 Yeager, Leland B. 24, 25 Zaida, Mahmood A. 139